Fiscal Sustainability: Debt Management Performance Audit

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1 Fiscal Sustainability: Debt Management Performance Audit February 2014 Office of the Auditor Audit Services Division City and County of Denver Dennis J. Gallagher Auditor

2 The Auditor of the City and County of Denver is independently elected by the citizens of Denver. He is responsible for examining and evaluating the operations of City agencies for the purpose of ensuring the proper and efficient use of City resources and providing other audit services and information to City Council, the Mayor and the public to improve all aspects of Denver s government. He also chairs the City s Audit Committee. The Audit Committee is chaired by the Auditor and consists of seven members. The Audit Committee assists the Auditor in his oversight responsibilities of the integrity of the City s finances and operations, including the integrity of the City s financial statements. The Audit Committee is structured in a manner that ensures the independent oversight of City operations, thereby enhancing citizen confidence and avoiding any appearance of a conflict of interest. Audit Committee Dennis Gallagher, Chair Maurice Goodgaine Leslie Mitchell Rudolfo Payan Robert Bishop Jeffrey Hart Timothy O Brien, Vice-Chair Audit Staff Audrey Donovan, Deputy Director, CIA, CGAP, CRMA Chris Horton, Audit Supervisor, PhD, CGAP, CCSA, CRMA Marcus Garrett, Audit Supervisor, CIA, CGAP, CRMA Anna Hansen, Lead Auditor Robyn Lamb, Lead Auditor Bonnie Doty, Lead Auditor, MGPS Torry van Slyke, Senior Auditor You can obtain copies of this report by contacting us at: Office of the Auditor 201 West Colfax Avenue, Department 705 Denver CO, (720) Fax (720) Or download and view an electronic copy by visiting our website at:

3 City and County of Denver 201 West Colfax Avenue, Department 705 Denver, Colorado FAX Dennis J. Gallagher Auditor February 20, 2014 Cary Kennedy, Deputy Mayor, Chief Financial Officer Department of Finance City and County of Denver Dear Ms. Kennedy: Attached is the Auditor s Office Audit Services Division s report of its audit of the City s debt management. The purpose of the audit was to assess the effectiveness of debt management, specifically focusing on assessing the use of Certificates of Participation (COPs). We also sought to understand the role of special districts created by the City as it relates to debt management, and determine the extent to which these districts add to the tax burden of Denver citizens. My team found that the City generally has a strong internal control structure in place for its debt management, and I commend the Department of Finance for the City s strong debt rating from the three major rating agencies. In addition, I m happy to report that the use of special districts by the City and County of Denver has not created a widespread, significant tax burden for Denverites. However, I encourage you develop some improvements in the use of COPs for greater transparency and consistency. The citizens of our City have a right to expect that their tax dollars will be used effectively, and that they will have significant input into any process that may result in the use of general tax monies. If you have any questions, please call Kip Memmott, Director of Audit Services, at Sincerely, Dennis J. Gallagher Auditor DJG/cnh cc: Honorable Michael Hancock, Mayor Honorable Members of City Council Members of Audit Committee Ms. Janice Sinden, Chief of Staff Ms. Beth Machann, Controller Mr. Scott Martinez, City Attorney To promote open, accountable, efficient and effective government by performing impartial reviews and other audit services that provide objective and useful information to improve decision making by management and the people. We will monitor and report on recommendations and progress towards their implementation.

4 Ms. Janna Young, City Council Executive Staff Director Mr. Brendan Hanlon, Budget Director Mr. Robert Gibson, Director of Cash, Risk, and Capital Funding Mr. Patrick Heck, Chief Financial Officer, Department of Aviation Mr. L. Michael Henry, Staff Director, Board of Ethics To promote open, accountable, efficient and effective government by performing impartial reviews and other audit services that provide objective and useful information to improve decision making by management and the people. We will monitor and report on recommendations and progress towards their implementation.

5 City and County of Denver Dennis J. Gallagher Auditor 201 West Colfax Avenue, Department 705 Denver, Colorado FAX AUDITOR S REPORT We have completed an audit of the City s debt management. The purpose of the audit was to assess the effectiveness of debt management, including Certificates of Participation (COPs). We also assessed whether special districts add to the tax burden of Denver citizens. This performance audit is authorized pursuant to the City and County of Denver Charter, Article V, Part 2, Section 1, General Powers and Duties of Auditor, and was conducted in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives. The audit found the City has implemented key debt management internal controls; however, the City has not always provided sufficient revenue sources to fund debt service payments or consistently applied COP criteria. While some COPs have demonstrated cost savings and increased efficiencies for the City, two COPs were insufficiently funded resulting in the allocation of taxpayer funds to satisfy the annual lease payments. Further, the audit found that only a small percentage of the City is affected by overlapping taxes created by the City s active special districts, some of which impose and collect mill levies. We extend our appreciation to the Chief Financial Officer and her team of professional financial managers, as well as to the other individuals who assisted and cooperated with us during the audit. Audit Services Division Kip Memmott, MA, CGAP, CRMA Director of Audit Services To promote open, accountable, efficient and effective government by performing impartial reviews and other audit services that provide objective and useful information to improve decision making by management and the people. We will monitor and report on recommendations and progress towards their implementation.

6 City and County of Denver Office of the Auditor Audit Services Division REPORT HIGHLIGHTS Fiscal Sustainability: Debt Management February 2014 The audit report, the second in a series that results from an audit of City fiscal sustainability, resulted from a review of current City practices on debt management, special districts, and Certificates of Participation. Background The City and County of Denver incurs debt and other obligations to fund investments that help finance capital improvement initiatives approved by the voters of Denver, purchase equipment, or secure capital leases. Issuing debt and other obligations allows the City to implement critical capital improvement projects when sufficient cash is not available. As of December 31, 2012, total outstanding debt and other obligations of the City was $5.6 billion, of which $3.9 billion is from DIA and other enterprise funds. Purpose This audit had two audit objectives: to understand the basic debt management practices and processes and assess the effectiveness of debt management, including internal controls; and to understand the role of special districts created by the City as it relates to debt management, and determine the extent to which these districts add to the tax burden of Denver citizens. Highlights The audit found the City has various key debt management internal controls in place to ensure compliance with State Constitution and City Charter provisions. The implementation of these controls has helped the City obtain the highest rating on its General Obligation bonds. The audit also found Certificates of Participation (COPs) provide financing flexibility for the City. However, while some COPs have demonstrated cost savings and increased efficiencies for the City, two COPs were insufficiently funded resulting in the allocation of taxpayer funds to satisfy the annual lease payments. One project funded by COPs also did not meet the economic criteria set forth in the City s COP Guidelines. In addition, more could be done to enhance transparency for its various stakeholders by proactively alerting citizens and other stakeholders of upcoming financing mechanisms not requiring public vote. Finally, the audit provides assurance that the Department of Finance monitors special districts taxing status and debt obligation through risk assessments of revenues and expenditures, and that only a small geographic area of the City is affected by overlapping taxes of active special districts imposing and collecting additional mill levies.

7 TABLE OF CONTENTS INTRODUCTION & BACKGROUND 1 SCOPE 12 OBJECTIVES 12 METHODOLOGY 13 FINDING 1 15 The City Has Adopted Key Debt Management Practices, but Some Governance Improvements Are Needed for Certificates of Participation 15 RECOMMENDATIONS 24 FINDING 2 25 Special Districts Can Issue Debt, but Most of The City s Geographic Area Is Not Impacted by Special District Taxes 25 RECOMMENDATIONS 30 APPENDICES 31 Appendix A: Glossary 31 Appendix B: GIS Maps 32 AGENCY RESPONSE 33 * This document contains interactive text and graphics which activate/deactivate when selected.

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9 INTRODUCTION & BACKGROUND The City and County of Denver Incurs Debt and Other Obligations The City and County of Denver (City) incurs debt and other obligations to fund investments that help finance capital improvement initiatives approved by the voters of Denver, purchase equipment, or secure capital leases. The total outstanding debt and other obligations of the City as of December 31, 2012, was $5,554,776,000. This includes debt and other obligations of governmental activiti totaling $1,626,712,000 and sbusiness-type activitiestotaling $3,928,064,000. Issuing debt and other obligations allows the City to implement critical capital improvement projects when sufficient cash is not available. In a 2005 review, the City s Infrastructure Task Force (ITF) found approximately $27.5 million in annually deferred capital maintenance. In 2007, the Infrastructure Priorities Task Force further determined there was a current backlog of deferred maintenance projects in excess of $390 million in addition to the FOR READERS OF THE ELECTRONIC VERSION OF THE REPORT Some technical financial terms in the Introduction & Background chapter contain hyperlinks to their definitions. Select a hyperlink for a word s definition, and select again to hide the definition. A list of these definitions is also found in Appendix A of this report. $27.5 million identified by the ITF. In response, voters approved the Better Denver Bond Program and the Capital Maintenance Mill Levy in This voter-approved bond levy addressed some major deferred infrastructure maintenance projects by using annually appropriated funds to maintain existing capital assets. 1 Overview of Key City Personnel Responsible for the Capital Improvement Program and Issuance of Debt and Other Obligations The annual capital planning process is a collaborative effort and requires the cooperation of many groups within the City. The Capital Improvement Program (Program) has many functions, including identifying capital maintenance and expansion priorities for the annual budget and establishing the Six-Year Capital Improvement Plan (Plan). 2 The capital planning and debt issuance processes involve various City personnel. 3 1 City and County of Denver, Colorado Six-Year Capital Improvement Plan , Six Year Capital Improvement Plan 2 City Charter mandates a six-year capital planning process. 3 All information in this section was derived from the City and County of Denver, Colorado Six-Year Capital Improvement Plan , Six Year Capital Improvement Plan, and from the City s Department of Finance website. P a g e 1 Office of the Auditor

10 City agencies City agencies develop capital maintenance priorities, identify required payments, and develop a list of prioritized discretionary project requests for submittal to the Budget and Management Office (BMO). Budget and Management Office BMO prepares and provides agencies with instructions and guidelines for the Program and Plan. BMO also reviews the prioritized lists of discretionary projects and works with City agencies and the Mayor s Office to recommend which of these capital projects can be undertaken within the available funds. This recommendation is made to the Development Council. Development Council The Development Council includes representatives from the Mayor s Office as well as Public Works, Parks and Recreation, Community Planning and Development, Finance, Environmental Health, Denver International Airport (DIA), the Office of Economic Development, the City Attorney s Office, and the Denver Urban Renewal Authority (DURA). The Development Council drafts the annual capital budget, which is submitted to the Mayor and City Council. The Development Council also serves as the advisory body that recommends discretionary projects to be completed with currently available capital funding, once commitments to payments and capital maintenance are realized. Further, the Development Council recommends to the Mayor and City Council the use of debt financing for deferred discretionary projects, which may be funded through instruments including General Obligation Bonds (GO bonds), revenue bonds, and Certificates of Participation (COPs). The deferred projects are identified in two work plans higher priority projects are included in the Six-Year Work Plan ($373 million) and lower priority projects are added to the Six to Twelve Year Work Plan ($237 million). The sixty-two projects within these two work plans are assigned to one of three prioritization tiers. The highest priority projects are assigned to Tier 1 (forty projects) and Tier 2 (nineteen projects). Examples include the Cherry Creek Transfer Station (Phases 2 and 3), Police Substation District 6 Replacement, 911 Communications Facility Replacement, and Colfax Transit Implementation (Auraria to Yosemite Street). Tier 3 projects (three projects) can be accomplished within a six to twelve year timeframe. Examples include the Colorado Convention Center Mechanical Systems and Multimodal Street Reconstruction Program. Cash, Risk, and Capital Funding (CRCF) Located within the Department of Finance, CRCF oversees the City s debt issuance and administration process for City debt and other obligations. The Capital Funding Section within CRCF oversees all bonds and other obligations of the City and its enterprises including GO bonds, revenue bonds, lease purchase agreements, and COPs. Therefore, CRCF is responsible for determining the best financing instrument with which to fund a project, and presents the financing options to the Mayor s Office and City Council for approval. The Capital Funding Section also oversees special district and economic development related activities, such as the issuance of Private Activity Bonds related to housing and economic development needs and the creation and monitoring of Metropolitan, Business Improvement, and General Improvement Districts. The following figure outlines the Capital Funding Section s debt issuance responsibilities. City and County of Denver Page 2

11 Pre-Issuance Assisting agencies with capital needs to find the most efficient and effective financing solution, scheduling and deal flow Ensuring obligations are issued in accordance with federal laws and regulations, Colorado state law, City Charter and the Debt Policy Issuance Transaction coordination and management, including assisting the marketing effort for bonds Coordinating the bond pricing and closing Coordinating final sign-off on the pricing and final terms of the bonds within the parameters of the Bond Ordinance Post Issuance Identifying and managing risk of outstanding obligations Identifying restructuring opportunities and ongoing disclosure of outstanding obligations Regular reporting and covenant compliance activities Source: Department of Finance and Denver International Airport, City and County of Denver Capital Financing, February 2, Capital Lease Finance Committee Representatives from the Purchasing Division, CRCF, BMO, and the City Attorney s Office meet as needed to review potential capital equipment, machinery, and computer or software purchases for which capital lease financing may be a possibility. This financing option is generally used for items of lower dollar value than the projects identified and addressed by the Development Council. As of December 31, 2012, outstanding capital leases totaled $15.4 million. Examples of items purchased through capital leases include snow plows and loaders ($421,921 outstanding), GenTax software ($2.034 million outstanding), and crime lab equipment ($1.158 million outstanding). This committee is responsible for making the final determination to go forward with capital lease financing. Based on input from City agencies during the annual budget process, BMO representatives are responsible for identifying and approving equipment that might require financing through a lease purchase transaction. The Purchasing Division is responsible for working with each agency to prioritize and coordinate the acquisition of approved equipment. Representatives of CRCF are responsible for reviewing financing bids and recommending the entity to provide the financing and assist the City Attorney s Office in drafting the Lease Purchase Agreement. City Council City Council discusses and approves the annual capital budget as part of the City s annual budget process. In addition, City Council reviews and approves issuances of financing instruments brought to them by CRCF. Once approved, City Council will pass an ordinance to initiate the financing. Page 3 Office of the Auditor

12 Most Debt Issued by the City Takes the Form of GO Bonds and Revenue Bonds The City issues multiple types of long-term debt to finance capital equipment and property projects. Most debt is issued through GO bonds and Revenue Bonds. 4 Allocation of Outstanding Debt and Other Obligations The total outstanding debt and other obligations of the City as of December 31, 2012, was $5,554,776,000. This includes debt and other obligations of governmental activities totaling $1,626,712,000 and business-type activities totaling $3,928,064,000. As shown in Figure 1, GO bonds comprise the majority of the City s 2012 governmental activities outstanding debt with 55 percent, while COPs are the next largest with 27 percent. Figure 1: Governmental Activities Debt and Other Obligations by Type General Obligation Bonds: 55% Capital Leases: 27% Excise Tax Revenue Bonds: 14% Notes Payable: 1% Unamortized Premium: 3% Source: City of Denver 2012 CAFR: Ratios of Outstanding Debt by Type. 4 All information in this section was derived from the Approved 2013 Budget, the City s 2012 Comprehensive Annual Financial Report, various Colorado Revised Statutes and City and County of Denver Charter sections, and the City s Debt Policy, Capital Lease Financing Policy, and COP Guidelines. City and County of Denver Page 4

13 Figure 2 shows the types of the $3,928,064,000 outstanding debt for businesstype activities as of December 31, These activities include outstanding debt of the City s following Aviation Enterprise Fund, Wastewater Management Enterprise Fund, and Golf Enterprise Fund. DIA s outstanding revenue bonds represent 98 percent of all 2012 outstanding enterprise funds debt. Figure 2: Business-Type Activities Debt and Other Obligations by Type Revenue Bonds: 95% Notes Payable: 1% Unamortized (Discount)/ Premium: 4% Source: City of Denver 2012 CAFR: Ratios of Outstanding Debt by Type. GO Bonds Are the Most Commonly Used Type of Governmental Activity Debt GO bonds are tax-exempt, long-term debt issued directly by the City to fund capital improvements clearly benefiting the broad public interest, such as roads and public facilities. Essential public projects without associated revenue streams are the strongest candidates for GO bond financing. GO bonds may only be issued by voter approval and are secured by the full faith and credit of the City because the debt service payments are made from a dedicated General Fund property tax and other approved revenue sources. The majority of the debt incurred by the City is in GO bonds. Revenue Bonds Are a Type of Debt Used for Both Governmental Activity and Business Type Activity Debt Revenue bonds are tax-exempt, long-term debt issued to fund specific capital projects payable from a specific, dedicated revenue source. These bonds do not pledge the full faith and credit of the City. According to the City s Debt Policy, revenue bonds P a g e 5 Office of the Auditor

14 are appropriate if direct beneficiaries of a given improvement can be clearly identified and such beneficiaries can pay for a fair share of the improvement s costs. 5 Businesstype activity revenue bonds are not subject to City Charter debt limits, and do not require voter approval. However for revenue bonds that are not related to business-type activty debt and that are backed by new sources of revenue, voter approval is required. The majority of the City s revenue bonds-related debt is for three of the City s enterprise funds: the Aviation Enterprise Fund, which supports DIA; the Wastewater Management Enterprise Fund, which supports the City s wastewater and storm water sewer operations; and the Golf Enterprise Fund, which supports operations of the City s five municipal golf courses. The debt service payments related to these funds are made from new or renewed fees. Governmental activity revenue bonds are payable by certain excise tax. For example, excise tax revenue bonds have been issued to fund improvements to the Colorado Convention Center, which are payable from a portion of the lodger s tax, food and beverage tax, and short-term car rental tax, and to fund construction and expansion of the Denver Performing Arts Complex, which are payable from the facilities development tax and occupational privilege tax. COPs are lease purchase agreements in which a specific City capital asset serves as collateral COPs Provide Financing through Lease Purchase Agreements for the transaction. Since 2007, the outstanding amounts for COPs executed and delivered by the City have fluctuated between approximately $413 million (2007) and $442 million (2012). Lease Purchase Agreements Lease purchase agreements are one-year, renewable term agreements that do not constitute a general obligation or other indebtedness of the City and thus are not subject to any City Charter debt limitations or a vote of the people. The City acts as lessee and makes periodic rent payments to a lessor for the use of the leased property. The City s obligation to make lease payments is contingent upon City Council appropriating rental payments for the current fiscal year. In the event of non-appropriation of rental payments, the lease terminates and the City loses its right to the capital asset. Lease purchase agreements are entered into for smaller capital equipment acquisitions such as software, golf carts, or crime lab equipment. COPs Are a Type of Lease Purchase Agreement As with all other lease purchase agreements, COPs exist for a one-year, renewable term that does not constitute a general obligation or other indebtedness of the City. The required annual lease payments are subject to appropriation by City Council, and pursuant to the City s COP Guidelines must be funded by new revenue streams or measurable cost efficiencies or savings, which will be realized and dedicated to annual lease payments on the COPs. While COPs are not subject to City Charter debt limits, the City s Debt Policy limits annual 5 The City s Debt Policy, instituted in 1999, and was most recently revised in City and County of Denver P a g e 6

15 lease payments to no more than 5 percent of the General Fund or an enterprise fund s annual revenues. COPs are generally executed and delivered under a trust indenture (contract), trust agreement, or agency agreement between a lessor entity and a bank with trust powers (trustee). A COP represents a proportionate interest in the right to receive the revenues to be derived under the lease purchase agreement between the lessor and lessee (the City). 6 The trustee executes and delivers COPs. The City designates its interest in the lease revenues to the trustee. Annual lease payments are made to the trustee who then pays the investors. If the City fails to appropriate the lease payment, the City forfeits the leased property to the trustee for the benefit of the investors. COPs are sold to investors with the expectation that the City will continue the lease each year by appropriating funds for the annual lease payments. The essentiality of the leased property collateral securing the financing to the operation of the City provides purchasers of COPs increased assurance by reducing the possibility of the City terminating the lease. City s Use of COPs Has Fluctuated in the Period Figure 3 captures a ten-year trend of COPs and their outstanding amounts. The City s outstanding COPs were at the highest point in 2003, when the amount outstanding increased by 31 percent from Between 2003 and 2007, there was a steady decrease in the amount of outstanding COPs. Since 2007, the outstanding amounts have fluctuated between approximately $413 million (2007) and $442 million (2012). The 2013 outstanding amount of $415 million represents approximately $40 million in COP debt service payments approved by City Council. 7, 8 $490,000,000 $470,000,000 $450,000,000 $430,000,000 $410,000,000 $390,000,000 $370,000,000 $350,000,000 Figure 3: Outstanding COPs 10-Year Trend Source: Department of Finance Data 6 Colorado Municipal League. Financing Public Improvements While the amount of outstanding COPs has decreased since 2003, this does not necessarily indicate a decrease in COP issuances. This also reflects the drop in federal interest rates allowing the City to refund multiple series of COPs and realize savings in future interest payments, which are part of the total amounts outstanding. 8 Like other types of financing mechanisms, COPs can be refinanced, or refunded, to achieve better financing terms. For example, in the fourth quarter of 2013, the City went to market in a municipal auction and sold approximately $34 million in COPs. In the same auction, the City also refunded $122 million of GO bonds. Page 7 Office of the Auditor

16 Special Districts May Issue Debt for Specific Public Purposes Special districts provide a specific public benefit to a defined population within distinct boundaries. Special districts may be financed through the issuance of revenue bonds in which debt service payments are made from ad valorem taxes or fees collected from property owners in the district boundaries. Special district debt is not a direct obligation of the City, but it does require the vote of the affected property owners. When ad valorem taxes are assessed or increased, the result is a higher overall tax burden for the property owners overlapping taxes in special districts compared to residents residing in areas of the City not within special districts. These property owners paid taxes at the standard mill levy rate of , for the 2012 tax year payable in Therefore, the City must coordinate closely with special districts to avoid placing too much tax burden on taxpayers residing in overlapping taxing areas. City Charter Special Districts Special districts created by the City under authority of City Charter help manage the costs of constructing and maintaining local public improvements. They can be financed through the issuance of bonds or the appropriation by City Council of monies received from assessments made on properties benefitting from the improvement. Benefited properties will be assessed a proportionate share of the cost of the improvement, while voter authorization is required to issue new money bonds. There are two types of special districts established pursuant to City Charter; Local Improvement Districts (LIDs) and Local Maintenance Districts (LMDs). Both LIDs and LMDs can be initiated by a petition signed and filed by the property owners in the proposed district or by the Manager of Public Works. LIDs are created pursuant to the authority of Denver Revised Municipal Code (D.R.M.C.) 7.6.1, to fund neighborhood improvement construction such as paving of streets and alleyways; curbs and gutters; sidewalks; streetscape amenities benches, lights, and vegetation; wastewater lines; and storm drainage systems. LMDs are created pursuant to the authority of D.R.M.C , to fund the continuing care, operation, security, repair, and maintenance of improvements within pedestrian areas of the public right-of-way. Statutory Special Districts Statutorily-created special districts have the ability to issue general obligation debt and consequently tax the residents to pay for that debt. They can repay the debt through assessments; rates, fees, tolls and charges; or property taxes levied upon property of land owners within the special district. There are two types of special districts established by Titles 31 and 32 of the Colorado Revised Statutes (C.R.S.). The City utilizes Title 31 Business Improvement Districts (BIDs) and General Improvement Districts (GIDs) and Title 32 Metropolitan Districts. BIDs are created 9 A mill represents $1 per $1,000 of assessed value. The assessed value of a property is based on the assessment rate, which in Denver is either 29 percent of the actual value of commercial properties or 7.96 percent of the actual value of residential properties. For more information, see the Denver Assessor s webpage at City and County of Denver Page 8

17 for commercial purposes only, and may be used to construct, finance, install, and operate improvements such as streets, sidewalks, streetlights, utilities and drainage facilities, landscape, decorative structures, and off-street parking. Examples of BIDs within the City are the Downtown Denver and Cherry Creek North BIDs. 10 GIDs may be used to construct, acquire, and implement any public improvement (whether commercial or residential) except solid waste disposal improvements and services. GIDs may consist of non-contiguous land parcels and may be organized wholly or partially within an existing special district if the existing district does not already provide the service proposed by the GID. Examples of GIDs within the City are the 14th Street and Gateway Village GIDs. Title 32 Metropolitan Districts can provide services and improvements (whether commercial or residential) such as ambulance service, fire protection, hospitals, mosquito control, parks and recreation, safety protection, sanitation, street improvements, and water and wastewater developments. Metropolitan Districts are formed upon approval by City Council of the district s service plan the document that governs the district s actions. Examples of Metropolitan Districts are the Highlands Ranch Community and the five Denver Union Station Metropolitan Districts. Both the State of Colorado and the City of Denver Have Implemented Debt Requirements The City is subject to various external requirements and internally developed practices regulating debt issuance. Requirements outside the City s control include the Taxpayer Bill of Rights (TABOR) portion of the Colorado State Constitution, City Charter language requiring voter approval and debt limits, as well as review of the City s debt issuances by national rating agencies. Internal practices overseeing the debt issuance process include the involvement of various City divisions, such as City agencies, BMO, CRCF, Development Council, Capital Lease Finance Committee, and City Council. In addition, there are City Charter rules covering bond issuances, and City Debt, Capital Lease Financing, and COP policies are in place. Voter Approval Requirements and Debt Limits Colorado State Constitution Article X, Section 20 TABOR requires the City to obtain voter approval prior to issuing any multiyear fiscal debt or obligations, except for debt issued by City enterprises and when refunding outstanding bonds. Additionally, Article XI, Section 6 limits the amount of general obligation debt political subdivisions may incur provided by the charter of a home rule city and county, city, or town and excludes general obligation water bonds from the limitation. D.R.M.C establishes the debt limitation for GO bonds at 3 percent of actual valuation of taxable property within the City. 10 The City also uses Title 31 Tax Increment Financing Districts (TIFs); however, a review of TIFs was not conducted as part of this audit. TIFs are used by the Denver Urban Renewal Authority (DURA) to finance redevelopment of blighted property in the City. We plan to issue an audit of the DURA, including TIFs, in Page 9 Office of the Auditor

18 As shown in Figure 4, the City s GO bonds have historically been well below the maximum GO debt allowable. For example, in 2012, the debt limit was $2,300,923,000, while the actual outstanding GO bonds chargeable to the limit were only $895,649, $2,500,000 Figure 4: Computation of the General Obligation Debt Margin ($ in thousands) $2,000,000 $1,500,000 $1,000,000 Maximum General Obligation Debt (3% of total valuation) Bonds Chargeable to Limit $500,000 $ Source: Annual City and County of Denver Financial Disclosure Statements Internal Rules, Policies, Guidelines, and System D.R.M.C through establishes rules governing bond issuances, including, but not limited to, the use of a financial advisor, notifying the City Council in advance of any bond issuances, and refunding requirements. The City Debt Policy prescribes that the City consult with external legal and financial consultants on debt obligations, including the use of bond counsel and financial advisors. To further structure debt-related activities, the City has adopted additional written guidelines specific to capital leases and COPs. In addition, the City utilizes a debt management database to track and manage outstanding long-term debt and other obligations, including general obligation and revenue bonds, Capital Leases, and COPs. Transparency Transparency is one of the cornerstones of democracy. Through greater insight into the activities of government, citizens are better able to hold their elected officials and the civil servants accountable for their actions. The City provides a significant amount of debt-related financial information to citizens and other stakeholders to enhance transparency and accountability, including the City s Proposed and Adopted Budgets, the Comprehensive Annual Financial Report, the annual debt Disclosure Statement to City investors, and the Popular Annual Financial Report and Citizens Budget, which are both aimed at non-financial experts. These various financial publications provide debt information including, but not limited to, the amount of debt outstanding, recently 11 The debt limit of $2,300,923,000 is 3 percent of $76,697,449,000, which is the 2012 assessed valuation of taxable property in Denver. City and County of Denver Page 10

19 completed or upcoming debt transactions, refundings, and swap agreements. This debtrelated information is presented on the City s Transparent Denver webpage, which enhanced the City s transparency efforts when it came online in July Related Terms Due to the complexity surrounding debt management, we have provided definitions of additional debt-related terms. While these terms may not be presented in the audit report findings, they provide additional context and understanding of an overall debt management process. Bond Rating A bond rating is the method of evaluating the quality and safety of a bond. This rating provides a relative measure of risk and uncertainty that reflects an issuer s ability and willingness to repay the debt incurred and the likelihood of default. The City s credit is reviewed annually, and all new City debt and other obligation issuances undergo a comprehensive review, resulting in a rating at the time of issuance. In 2012, the City s GO debt received a Triple-A rating the highest rating from the three major credit rating agencies. 13 Issuances of revenue bonds and COPs are generally rated lower than GO bonds because they are not backed by the full faith and credit of the City like GO bonds. A lower bond rating can increase the amount of interest that will be paid on a debt issuance. 14 Debt Service Fund A fund in which monies are deposited to assure the timely availability of sufficient funds for the payment of debt service requirements. Typically, the amounts of the revenues to be deposited into the debt service fund and the timing of such deposits are structured to ensure a proper matching between debt service fund deposits and debt service payments becoming due. 15 Debt Reserve Fund A fund in which monies are deposited to be applied to pay debt service if pledged revenues are insufficient to satisfy the debt service requirements. This fund may be funded with bond or other obligation proceeds at the time of issuance, through the accumulation of pledged revenues, with a surety or other type of guaranty policy, or only upon the occurrence of a specified event (e.g., upon failure to comply with a requirement in a bond contract). 16 Non-Recourse Debt This type of debt is issued pursuant to Executive Order No. 90. Nonrecourse City debt includes: 1) bonds issued for affordable housing, such as to stimulate the affordability of for sale and rental housing within the City; 2) industrial development revenue bonds, which are private activity bonds for those private sector industrial facilities permitted to be financed under both federal and state statutes, and; 3) 501(c) 12 See our Fiscal Sustainability: Financial Condition and Transparency audit report issued in December 2013, at the Denver Auditor's website. 13 Fitch, Moody s, and Standard and Poor s. 14 Department of Finance and Denver International Airport, City and County of Denver Capital Financing, February 2, Municipal Securities Rulemaking Board (MSRB), accessed December 11, 2013, MSRB Glossary. 16 Ibid. Page 11 Office of the Auditor

20 (3) bonds, which further the objectives of qualified non-profit entities consistent with City policies. 17 Refunding Refunding is the process of refinancing outstanding debt by issuing new debt. The City Debt Policy allows for refunding to generate interest savings, restructure debt service, or eliminate burdensome covenants; however, to be worthwhile the refunding transaction should achieve 5 percent net present value savings of the amount of debt being refunded. 18 Swap Agreements The intent of a swap agreement is to protect the City against rising variable interest rates. The swap agreement is a specific derivative contract entered into by the City and a swap provider to exchange periodic interest payments. The swap allows the City to synthetically fix the interest rate it pays in exchange for payments based upon a variable rate. As of December 31, 2012, the City had swap agreements in conjunction with each of the three Webb Building COPs. All other swap agreements were with regard to DIA revenue bonds. 19 SCOPE This audit report resulted from a review of current City practices regarding debt management, current City practices regarding special districts, and Certificates of Participation (COPs) issued by the City for five locations: the Wellington Webb Municipal Office Building; the Central Platte Campus; the Denver Botanic Gardens; the Denver Museum of Nature and Science; and the Blair-Caldwell African-American Research Library. This report is the second in a series that results from an audit of City fiscal sustainability. The first report, issued in December 2013, covered financial condition analysis and the transparency of City financial reporting. 20 OBJECTIVES This report addresses two audit objectives. We sought to understand basic debt management practices and processes and assess the effectiveness of debt management, including internal controls. As part of this objective, we specifically focused on assessing the use of COPs. We sought to understand the role of special districts created by the City as it relates to debt management, and describe the geographic extent to which these districts add to the tax burden in Denver. 17 City Debt Policy, Municipal Securities Rulemaking Board (MSRB), accessed December 11, 2013, MSRB Glossary and City Debt Policy, MSRB, accessed December 11, 2013, MSRB Glossary and Department of Finance and Denver International Airport, City and County of Denver Capital Financing, February 2, See Fiscal Sustainability: Financial Condition and Transparency at the Denver Auditor's website. City and County of Denver Page 12

21 METHODOLOGY This report utilizes various standard information-gathering techniques, as well as a comprehensive approach to assess the City s financial condition. Standard Techniques for Gathering Information In keeping with our standard information-gathering approach, the audit team interviewed various individuals, reviewed a wide variety of documents, conducted observations, and performed data analyses. Specifically, we interviewed numerous officials and employees within the Department of Finance and reviewed myriad City finance documents to develop information for this report. Among the documents we reviewed were the City s 2012 and 2013 budgets, the City s CAFRs from 2002 through 2012, the management letters issued by the City s external auditor for the 2002 through 2012 CAFR audits, City Fiscal Accountability Rules, the City s Debt Policy, City Disclosure Statements, and the covenants for various series of GO bonds and COPs. We also interviewed the City s outside bond counsel and observed an auction at which Finance Department staff and an outside consultant assisted the City in refunding (refinancing) certain GO bonds. Further, we took a guided tour of the Blair-Caldwell African-American Research Library to better understand the facility and the services it provides to the community. Finally, we reviewed and analyzed data from the City s debt management information system. GIS Data In addition to traditional methodologies, auditors used Geographic Information Systems (GIS) to determine the relative property tax burden of residential and commercial properties across the City. Auditors created the maps in this report using ArcGIS, proprietary GIS software. We used GIS to identify areas of overlapping special taxing districts in the same geographic location; to determine the number of overlapping districts in the same geographic location; to calculate the cumulative mill levies in these overlapping areas; to present the status of activity (active and inactive) of special taxing districts; and to present all of the above analyses in a spatial, visual format. Data were obtained from the GIS repository at the City and County of Denver, which is maintained by Technology Services. Auditors collected existing datasets, called shapefiles, for special taxing districts including metropolitan districts, general improvement districts, business improvement districts, and other special districts such as water and sanitation districts. According to the source documents, these datasets were updated and verified in August Additional data were collected to prepare the shapefiles for analysis. First, mill levy data from 2012 were obtained from documents provided by the Department of Finance, and these data were added to the underlying tables contained within the shapefiles. Next, auditors also developed a scale to classify each special district according to its level of activity, from inactive to active with authority to issue additional debt. This information was also added to the underlying tables contained within the shapefiles. Then, the shapefiles were converted from geometrical format (polygon) to matrix format (raster) in order to perform calculations on the tabular data contained within those files. The rasters were then added together, as appropriate, in areas where district boundaries overlapped to determine cumulative mill levies and the number of districts in the Page 13 Office of the Auditor

22 overlapping areas. After the calculations were performed, the results were plotted on various maps, using neighborhood boundary and street data obtained from the City s GIS repository. City and County of Denver Page 14

23 FINDING 1 The City Has Adopted Key Debt Management Practices, but Some Governance Improvements Are Needed for Certificates of Participation The City has adopted some key debt management practices to monitor and manage debt in response to external debt requirements. The implementation of these processes has helped the City obtain the highest rating on its General Obligation (GO) bonds. Further, the City s external auditors have not reported any debt management-related internal control findings since Among the City s financial instruments are Certificates of Participation (COPs), which represent a flexible tool for the City to finance capital projects because Colorado State Constitution and City Charter provisions do not deem COPs long-term debt and therefore do not require voter approval for COPs. However, there are two current COPs that are being serviced using taxpayer-supported monies, but for which taxpayers had very limited input. Further, the City has not always consistently applied its specific criteria to all COP-funded projects. In some cases COP projects that do not meet economic criteria may still have a non-economic community benefit that justifies spending. In such cases, the City should take steps to help ensure that citizens have an opportunity to comment on the proposed COPs and thereby increase transparency and accountability. The City Has Adopted Key Characteristics of Effective Debt Management Oversight The City has various key debt management internal controls in place to ensure compliance with Colorado State Constitution and City Charter provisions. These internal controls include a written debt policy, which establishes internal guidelines, allowances, and restrictions that regulate the debt management in the City; additional guidelines on Capital Leases and COP financing; and a debt management database. In addition, the City s Debt Policy requires external guidance provided by bond counsel and financial advisors. Finally, the implementation of these controls has helped the City obtain the highest rating on its General Obligation (GO) bonds and helped ensure no recent debt management internal control findings from its external auditors. City Maintains a Debt Policy in Accordance with Best Practice and Some Minor Technical Updates are Needed In accordance with the Government Finance Officers Association (GFOA) best practices on debt management policy, the City established a written debt policy. GFOA recommends that state or local governments should write and adopt comprehensive written debt management policies to reflect laws and regulations. A well-developed debt policy helps improve the quality of decisions, articulate policy goals, provide guidelines for the structure of debt issuance, and demonstrate a commitment to long-term capital and financial planning GFOA, Best Practice: Debt Management Policy (1995, 2003, and 2012) (DEBT): October 2012, Page 15 Office of the Auditor

24 The City s Debt Policy establishes guidelines and parameters for the issuance and management of debt. According to this policy, the issuance of bonds, notes, COPs, and other securities by the City have significant impact upon citizens and therefore, debt issuances should be based on principles of equity, effectiveness, and efficiency. These principles are elaborated on in the chart below. Equity Effectiveness Efficiency The debt policy provides that those that benefit from the item financed should pay for it. The debt policy provides that once the transaction is completed, it accomplishes its intent and the identified revenue source for repayment is adequate to meet debt service. The debt policy provides that the relative cost of obtaining funds, including the costs of the financing and the costs of collecting pledged revenues, is better than competing alternatives. The City s Debt Policy also requires the evaluation and consideration of several factors when analyzing, reviewing, and recommending the issuance of debt, as outlined in the bullets below. Purpose, feasibility, and public benefit of the project Impact on credit agencies debt ratios and on General Fund Quantification of capital and election costs Availability of appropriate revenue stream(s) Aggregate debt burden upon the City s tax base Analysis of financing and funding alternatives Opportunity costs to other capital needs and City resources Political and policy implications The City s Debt Policy, instituted in 1999, was revised in 2005 and, according to the Department of Finance (Finance), is currently under revision. Our review of the 2005 version noted out-of-date language with regard to City divisions and personnel overseeing debt management. Therefore, the Chief Financial Officer should revise Debt Policy language to accurately reflect current roles and positions. Additional City Obligation Guidelines Augment the Debt Policy In addition to its existing Debt Policy and to further structure debt-related activities, the City adopted written guidelines for Capital Leases and COPs. While both capital lease and COP financing are considered capital leases, a lessor sells COPs to investors and shares its interest in the lease with investors. Properly structured, these financing tools are not legally defined as debt and are permissible under both the Colorado State Constitution Taxpayer Bill of Rights (TABOR) and City Charter. Capital Lease Financing Policy According to the City s Capital Lease Financing Policy, capital leases usually transfer ownership of the property to the City, contain a bargain purchase option, have a lease term equal to 75 percent or City and County of Denver Page 16