DEBT ISSUANCE MANUAL SEPTEMBER Published by the League of Oregon Cities

Transcription

1 L E A G U E O F O R E G O N C I T I E S DEBT ISSUANCE MANUAL SEPTEMBER 2007 Published by the League of Oregon Cities

2 LEAGUE OF OREGON CITIES DEBT ISSUANCE MANUAL LEAGUE OF OREGON CITIES 1201 Court Street NE, Suite 200 Salem, Oregon Phone: (503) Fax: (503) Web:

3 DISCLAIMER: Nothing in this manual should be construed or relied upon as legal or financial advice. Instead, this manual is intended to serve as an introduction to the general subject of debt issuance, from which better informed requests for advice, legal and financial, can be formulated. All rights reserved. No part of the League of Oregon Cities Debt Issuance Manual may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording or any other storage and retrieval system, without written credit given to the League of Oregon Cities.

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5 ACKNOWLEDGMENTS The inaugural 2007 edition of the League of Oregon Cities Debt Issuance Manual has been developed to assist city officials with public finance and debt issues, taking into account the laws governing public finance in Oregon. This significant undertaking developed as a result of comments and conversations at the annual Bonds and Ballots conference which the League of Oregon Cities Oregon Local Leadership Institute jointly offers with the Oregon School Boards Association. The Manual covers the basic financing tools available to fund public projects and many of the requirements for using each tool. In addition, steps for the approval and issuance of bonds and levies have been included. This publication will be useful for the lay council person or citizen, as well as the city s finance professionals, the city manager, city attorney and others. This document represents the combined work effort of the staffs of the League of Oregon Cities, the Pacific Northwest offices of the law firm Orrick, Herrington & Sutcliffe LLP, the investment banking firm Seattle Northwest Securities Corporation and the public relations firm of C&M Communications. The principal inspirations for this publication are Jennie Messmer of the League of Oregon Cities and Douglas Goe, partner in-charge of the Pacific Northwest offices of Orrick, Herrington & Sutcliffe LLP. David Taylor, Vice President, Seattle Northwest Securities Corporation, is especially commended for his singular authorship of many of the chapters in the Manual. Sincere thanks goes to Jeanne Magmer of C&M Communications for her contribution to the Bond Election Process chapter. Our appreciation to Naomi Keck of the investment services advisory firm Bond Logistix LLC for her review of the Eligible Investments and Bond Related Funds chapter. The other team members from Orrick s staff include Michael Schrader, Scott Schickli, Courtney Muraski, Christine Reynolds, Greg Blonde, Angela Trout and Lee Helgerson. Many thanks also to Dawn Evans for her review and word processing expertise and assistance in assembling the final product. Special recognition and acknowledgment goes to the California Debt and Investment Advisory Commission for the use of the General Federal Tax Requirements chapter in this publication. The 2007 Manual incorporates current requirements and laws as of June, The League intends to periodically update the information contained in this publication in order to maintain its currency and correctness especially in regards to changes in law or other events. For printed copies of the Manual contact the League of Oregon Cities at (503) or to

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7 TABLE OF CONTENTS PAGE CHAPTER 1: OVERVIEW OF DEBT FINANCING... 1 The Municipal Debt Market... 1 Capital Markets at Work... 2 Methods of Sale...5 The Bond Sale... 6 Frequently Asked Questions... 7 CHAPTER 2: ROLES AND RESPONSIBILITIES OF PRINCIPAL PARTICIPANTS The Issuer Legal Counsel Financial Services Selecting the Finance Team Frequently Asked Questions CHAPTER 3: BASIC LEGAL DOCUMENTS Authorizing Resolution Bond Indenture Official Statement Bond Purchase Agreement Official Notice of Sale Continuing Disclosure Certificate Conduit Borrowing Documents Loan Agreement Insurance and Credit Enhancement Related Agreements Tax Certificate Bond Counsel Opinion and Other Legal Opinions Closing Documents Frequently Asked Questions CHAPTER 4: SECURITIES LAW AND DISCLOSURE Federal Securities Law Disclosure Obligation When Issuing Bonds Disclosure Obligations Following Issuance of Bonds Avoiding Securities Law Claims i

8 TABLE OF CONTENTS PAGE CHAPTER 5: GENERAL FEDERAL TAX REQUIREMENTS Obligations of a State or Political Subdivision Definitions Private Activity Bonds Qualified Private Activity Bonds Arbitrage Bonds Rebate Requirement Rebate Exceptions Fair Market Value Rules Hedge Bond Restrictions Refunding Bonds Federal Tax Limitations on Investing Bond Proceeds CHAPTER 6: STATE AND LOCAL GOVERNMENT LAW AND DEBT POLICY Home Rule and City Charters Initiative and Referendum Powers Debt Policy Capital Improvement Plans Municipal Debt Advisory Commission Frequently Asked Questions CHAPTER 7: GENERAL OBLIGATION BONDS Electoral Requirements Allowable Use of Proceeds Debt limitations Notice of Classification of Uses Structuring of General Obligation Bonds Interest Rate Swaps with General Obligation Bonds Frequently Asked Questions CHAPTER 8: FINANCING AND LEASE PURCHASE AGREEMENTS Limitations Financing Agreement Documentation ii

9 TABLE OF CONTENTS PAGE Credit Structures Frequently Asked Questions CHAPTER 9: TAX INCREMENT AND ASSESSMENT FINANCINGS Tax Increment Financing Assessment Based Financings Frequently Asked Questions CHAPTER 10: REVENUE BONDS Uniform Revenue Bond Act Unique Credit Features of Revenue Bonds Frequently Asked Questions CHAPTER 11: CONDUIT REVENUE BONDS Legal Authority: Constitutional, Statutory and Administrative Rule Provisions Policy Considerations and Approval Process Authorized Projects Security and Sources of Repayment Revenues General Types and Purposes Special Tax Considerations Frequently Asked Questions CHAPTER 12: NOTES, SHORT-TERM AND INTERIM FINANCINGS Legal Authority Approval Process Manner of Sale Security and Source of Repayment Revenues Investment of Proceeds and Interest Earnings General Types of Short-Term Obligations Other Forms of Short-Term Borrowings CHAPTER 13: REFUNDINGS Reasons for Refunding Types of Refundings Frequently Asked Questions iii

10 TABLE OF CONTENTS PAGE CHAPTER 14: INTEREST RATE SWAPS AND OTHER DERIVATIVE FINANCIAL PRODUCTS Legal Authority: Constitutional, Statutory, and Administrative Rule Provisions Policy Considerations and Approval Process Using Interest Rate Swaps and Other Hedges Documentation of Interest Rate Swaps Evaluating and Managing Interest Rate Swap Risk Selection of Finance Team and Swap Counterparties Disclosure and Financial Reporting CHAPTER 15: LOCAL OPTION OPERATING AND MAINTENANCE LEVY Definition and Purpose Legal Authority and Approval Process Security and Source of Repayment CHAPTER 16: BOND ELECTION PROCESS The Bond Election Process Ballot Title Wording Requirements Conducting Successful Bond Elections Preparing City Information Election Dos and Don ts for Public Officials Public Employee Election Guidelines Frequently Asked Questions CHAPTER 17: STRUCTURING THE BOND ISSUE Fundamentals of Leveraging Sizing Bond Issues Issue Affordability Bond Characteristics CHAPTER 18: CREDIT RATINGS AND ANALYSIS Ratings and Rating Agencies Determining a Rating Assigning Ratings Deciding to Apply for a Rating iv

11 TABLE OF CONTENTS PAGE Bond Insurance Letters of Credit Frequently Asked Questions CHAPTER 19: ELIGIBLE INVESTMENTS AND BOND RELATED FUNDS Eligible Investments Bond Related Funds Frequently Asked Questions APPENDIX A: GLOSSARY TERMS AND CONCEPTS... A-1 APPENDIX B: U.S. GOVERNMENT AND AGENCY SECURITIES... B-1 APPENDIX C: LEGAL REFERENCES... C-1 APPENDIX D: PUBLIC FINANCE RESOURCES AND CONTACTS... D-1 v

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13 CHAPTER 1 OVERVIEW OF DEBT FINANCING This chapter introduces the financial markets and its players and discusses how debt is sold or placed with investors. Chapter 2, Roles and Responsibilities of Principal Participants discusses the roles and responsibilities of the issuers elected officials and staff and other market participants. Oregon municipalities are frequent issuers of tax-exempt bonds. From 1997 through 2006, Oregon municipalities (defined as all municipal issuers except the State of Oregon and education districts such as K-12 and community colleges) issued $15.4 billion of debt. This represented about 37 percent of the total tax-exempt debt issued in Oregon by all issuers during that period. For perspective, during the same period, the total municipal bond volume nationally was more than $3 trillion. The total Oregon market represented about 1.4 percent of the national market, and Oregon municipalities represented less than half of one percent of the national market. Why Debt? Borrowing for major project and infrastructure needs has a clear place in good public policy decision making. Borrowing allows municipalities to preserve existing resources for current needs. Borrowing accelerates the delivery of a needed asset or project. Borrowing can better allow a municipality to match expenditure of funds with a project s useful life and establish better ongoing fiscal discipline. In some cases, such as general obligation (GO) bonds, borrowing can provide new sources of funds to repay debt service not otherwise available to the municipality. Borrowing also may be necessary to bridge short term cash flow mismatches between operating needs and availability and timing of certain revenues. THE MUNICIPAL DEBT MARKET The municipal bond market is characterized by several key features. First, the market is populated with an enormous variety of credits. Second, most municipal bonds are issued as tax-exempt, which means the interest earned by bondholders is not subject to federal (and also usually state, if applicable) income taxation. A VARIETY OF CREDITS Nationwide, thousands of municipal bonds are issued every year. In some years more than 10,000 issuers sell tax-exempt debt. Issuers include the full range of municipal jurisdictions such as: States, cities, counties School districts and community colleges Chapter 1 Overview of Debt Financing 1

14 Municipal power authorities Transportation districts Urban renewal agencies Hospital districts Housing agencies Park, fire and water districts Private universities and other types of 501(c)(3) non-profits such as museums Oregon has all of these types of municipal entities and numerous others, all of whom have varying kinds of issuance authority. No two authorities are exactly the same. Because these issues are sold under different state laws, the municipal market is sometimes more regional than national. While Oregon municipal bonds usually are sold to investors nationwide, issuers are likely to find that financial consultants and bond counsel for their issues often come from regional or local service providers who understand local laws, regulations and customs. This is true for local issuers in other parts of the country as well. TAX EXEMPTION OF INTEREST Federal tax law allows municipal issuers to sell tax exempt debt under certain circumstances. The interest paid by these securities is exempt from federal, and in the case of Oregon issuers, Oregon personal income taxes. This tax-exempt status makes municipal bonds a desirable investment for investors who are willing to accept lower interest rates in exchange for the tax advantages municipal bonds offer. Tax-exempt status is a significant benefit to the issuer because of the lower interest cost. Tax exemption comes at a cost. Issuers must comply with numerous federal rules regarding the use of proceeds, the investment of proceeds and other aspects of the transaction. Chapter 5, General Federal Tax Requirements discusses federal tax law requirements and compliance. It is also worth noting that tax exemption of municipal bond interest is not constitutionally protected. Congress may revoke tax exemption of interest or otherwise change aspects of the federal tax law at any time. Issuers both in Oregon and nationally also sell some taxable debt because those issues may not comply with all the aspects required of tax-exempt debt. CAPITAL MARKETS AT WORK Most municipal debt issues are sold through the basic capital market mechanism. Rather than sell the debt directly to investors, municipalities typically use the services of an underwriter. The underwriter purchases the debt from the issuer and resells the bonds to investors. Issuers find this efficient because they do not need to maintain the specialized expertise needed to place debt. This method also typically results in the lowest cost of capital. Rather than try to find a single lender who will lend the issuer the needed amount of money, the issuer is, via the underwriter, 2 Chapter 1 Overview of Debt Financing

15 able to tap into dozens or hundreds of investors all willing to loan the issuer smaller amounts by purchasing specific pieces or maturities of a larger bond issue. The debt markets are different than the stock markets. Stock markets provide for a single exchange where all stock of a company is bought and sold. Stock markets provide for a single price discovery function; that is, buy or sell orders for a security that are placed at the same time are all executed at the same price. Bond markets are different in that the bond market is made up of hundreds of firms trading bonds. There is no central pricing function like in a stock exchange. Electronic trading, improved secondary market disclosure and increased price transparency has substantially improved bond pricing in the last decade, but the municipal bond market is still less commoditized than the market for U.S. Treasury securities. In order for capital markets like the bond market to work well, investors need to: Have confidence in the integrity of the system Have belief they will be repaid Have adequate information about the securities traded and sold and Have liquidity (the ability to get in and out of an investment) All of these themes form the foundation of much of the underlying details in this manual. To the extent a bond issue can fulfill the above criteria, the issue will be well received in the marketplace and, for example, obtain the best possible interest rates. To the extent any of these factors are weak, the ability of the issuer to obtain the best price, or at some point to sell the issue at all, will be diminished. To better understand the roles of the key participants in the bond markets, we briefly discuss the role of the investor and the underwriter and how bonds are sold in the marketplace. THE INVESTORS Investors purchase the municipalities debt. Because interest on municipal debt is usually exempt from federal and state taxes, these investors are looking to shelter income from taxation. The demand for tax-exempt debt is always subject to investors evaluation of tax-exempt securities versus higher yielding but taxable investments such as corporate stocks and bonds or U.S. Treasury bonds. The following table shows why an investor will accept substantially lower interest rates on tax exempt bonds. Tax Exemption Benefit Type of Bond 4.00% Tax exempt 5.97% Taxable Cash Investment $10,000 $10,000 Annual interest payment $400 $597 Less: federal income tax (33%) $0 $197 Net after tax return $400 $400 Chapter 1 Overview of Debt Financing 3

16 After tax yield 4.00% 4.00% (1)Assumes a marginal federal tax rate of 33% and no effect of State of Oregon income taxes. (2) Does not adjust comparable yields for credit quality. The investor s willingness to accept a much lower interest rate on tax exempt debt directly benefits the municipal issuer. Municipal issuers typically have no direct contact with the investors who purchase the municipality s bonds. Municipalities rely on underwriters to act as market intermediaries. However, issuers should understand what kinds of investors purchase municipal securities, what their preferences are and how those preferences will impact the issuer s debt structure and security features. Most investors who purchase municipal securities are seeking a fixed rate of return on their investment that is exempt from federal (and potentially state) income tax. These investors range from individuals to large institutional investors such as property and casualty insurance companies, money market funds and mutual funds. Broadly, the classes of investors who purchase municipal securities include: Retail or individual investors Retail investor proxies such as bank trust departments, investment advisors, taxexempt mutual funds and tax-exempt money market funds Institutional investors such as property and casualty insurers, corporations and bank portfolios Because investors interest in tax-exempt debt fluctuates with the investors profitability or tax status and the relative supply of tax-exempt bonds in the market, it is the underwriter s job to find the most aggressive set of buyers for an issuer s offering on the day it comes to market. Sometimes municipalities will actually sell their securities directly to investors. This generally occurs when vendors finance equipment or when municipalities place an issue directly to a bank portfolio. UNDERWRITING SYNDICATES, CO-MANAGERS AND THE SELLING GROUP Underwriters buy the bonds from an issuer and resell them to investors. Underwriters not only find investors for the issuer s bonds, they also take the risk out of the transaction for the issuer. Once the underwriter makes a firm offer to purchase the bonds, the issuer is not at risk if the underwriter cannot sell the bonds based solely on interest rate increases in the market. Sometimes, underwriters join together in a syndicate. Having more than one underwriter spreads the financial risk if the bond sale does not go well. When there is more than one 4 Chapter 1 Overview of Debt Financing

17 underwriter in a deal, one firm leads the transaction while the others take secondary roles. The lead firm is called the lead underwriter or senior manager. Other underwriters are called co-managers. There may be one or several co-managers, or none. The senior manager is responsible for interacting with the issuer, setting pricing terms for the bonds, managing the sale and allocating bonds to all investors at the sale s conclusion. Co-managers assist in the bond sale itself but generally have limited roles in other aspects of planning and executing the transaction. Syndicate firms agree upon a target percentage of the bonds to sell. For example, the senior manager may get 70 percent while a co-manager may get 30 percent. These percentages are only guidelines because actual orders dictate the number of bonds each firm receives at the end of the sale. However, if bonds go unsold, these percentages dictate each manager s liability for the unsold bond inventory. Selling group members are not syndicate members. Selling group firms are securities firms that have the right to put in orders for a new bond issue. Unlike co-managers, selling group members are not guaranteed that bonds will be allocated to them. However, selling group firms do not have any liability to take bonds if the sale goes poorly, nor are they required to order any bonds. METHODS OF SALE We now know that underwriters buy the bonds from issuers and resell them to investors. But how do the prices (that is, interest rates and terms) get established if there is no central pricing function like a stock market? The simple answer is that bond prices are like any other financial product prices are established by a negotiation between the investors and the underwriters. The investors clearly want to pay the lowest possible price (that is, get the highest possible interest rate or return) while underwriters want to get the highest possible price (that is, the lowest interest rate) for their clients. With dozens of issues in the market on any given day, and with increased price transparency, the negotiation is often over very small changes in rate or yield, as little as one or two basis points or %. The general level of interest rates for any given type of security are already pegged to what is going on with overall rates in the Treasury market. Municipalities may sell bonds in the public debt markets by: Putting the bonds out for a public bid (competitive sale) Working with a designated underwriter (negotiated sale) Issuers may also privately place debt issues directly with investors. This may take the form of a direct loan from a commercial bank or a placement to a limited number of sophisticated investors. Quality of service, issue size, credit rating, need for flexibility, costs of issuance, and market conditions, all come into play when deciding whether to privately place a debt issue or sell in the public markets through either a public bid or a negotiated process. Chapter 1 Overview of Debt Financing 5

18 Issuers choose a method based on which option offers the best overall service at the most reasonable cost for the time period of the bond sale. THE BOND SALE Issuers can choose from any number of financing process models. Some issuers choose to engage a financial advisor. Many larger municipalities elect to have an ongoing financial advisory relationship with a firm that advises them on debt related matters. The financial advisor will assist with the planning and execution of a competitive sale or assist with the selection of an underwriter in the case of a negotiated sale. Smaller entities may engage a financial advisor to assist only with a particular debt related project. Some municipalities elect not to use a financial advisor and work directly with their underwriter of choice on debt related matters. NEGOTIATED SALE Bonds may be sold through negotiation with an underwriter. By negotiating the sale of a bond issue, the municipality maintains control over which underwriting firm markets its bonds. One underwriting firm may be more qualified than another to structure or market an issue with unique aspects. If a municipality negotiates the bond sale with an underwriter, the municipality gains flexibility in adapting to changing conditions. Within the municipality s need for project money, the underwriter recommends the timing of an offering to coincide with a favorable market and receptive investors in an attempt to get the best interest rate for the issuer. Once a target sale date is selected, the underwriter continues to monitor the market and advise the issuer whether the sale should be accelerated or moved back, depending on market conditions. When the week of sale arrives, the underwriter provides preliminary interest rate estimates to the issuer, along with any available information regarding comparable sales. The day before the sale, the underwater schedules a pricing conference with the issuer to confirm the interest rates that the underwriter will offer to investors the next day. On the day of sale, the actual sale happens quickly. Typically, the formal sale or order period begins early in the morning and is concluded by midmorning. The underwriter tracks the amount of orders versus the amount of bonds available in each maturity. Where orders strongly exceed bonds available, the underwriter may be able to lower interest rates. Where orders do not match the amount of bonds available, the underwriter may need to raise rates in order to attract sufficient orders to sell the bonds. The underwriter reviews the results with the issuer and recommends whether any adjustments are necessary to conclude the sale process. The underwriter often takes a certain amount of unsold bonds into inventory to facilitate the completion of the underwriting in a timely manner. Once the issuer and underwriter agree on terms, they will execute a bond purchase agreement (BPA) that is the legally binding sale document. 6 Chapter 1 Overview of Debt Financing

19 COMPETITIVE BID SALE Bonds may be sold by public competitive sale. In a competitive sale, the terms of the issue, such as size, structure, maturity dates, amounts and redemption provisions, are determined several weeks prior to the sale and then published in a official notice of sale. Issuers strive to provide adequate notice of the sale to potential bidders in order to maximize the number of bids received. Official Notice of Sale. The official notice of sale contains the bidding rules, constraints, the amount and handling of the good faith deposit submitted by each bidder with its bid, and the method for evaluating the bids the issuer receives for the purchase of its bonds. The issuer establishes these terms in consultation with its financial advisor and bond counsel. Bond counsel typically prepares the notice of sale. Bidders (underwriters or syndicates of underwriters) base their bids on the salability of the debt, the stability of the bond market, and the pool of potential securities purchasers. The successful bidder establishes its reoffering prices to investors by considering comparable sales, what its investors are willing to pay, and the supply of bonds in the market waiting to be sold. In a competitive bid situation, the issuer hopes to receive numerous bids in response to its notice of bond sale, thereby increasing its chances of paying the lowest possible interest rate on its debt. To increase the odds of this happening, the bond sale should be set at a date and time when the bond market is most receptive to a new issue. Bids typically are calculated by the true interest cost (TIC) method (see Appendix A, Glossary Terms and Concepts). The financing team should set the bond sale date that best meets the issuer s needs to receive issue proceeds. Ideally, the sale should be held at a time when the market is not saturated with other similar issues. Sales on Tuesday, Wednesday and Thursday are preferable. Sales scheduled for Mondays and Fridays and days bracketing holidays and long weekends are less common but can be successful as well. Technology continues to change the way competitive sales are conducted to increase the number of bids an issuer receives. For example, bids are now commonly received electronically via the Internet-based bidding platforms. Surety policies rather than actual checks typically secure good faith deposits. FREQUENTLY ASKED QUESTIONS I don t understand the difference between what the federal government regulates and what the states regulate? State law governs what kinds of borrowing authority a municipality has and how it may be exercised. Laws differ widely between states what may be legal in one state may not be legal in another. Federal law governs whether interest on the debt may be exempt from federal income taxation and certain aspects of public offerings. Chapter 1 Overview of Debt Financing 7

20 Is it true that federal tax exemption of interest is not constitutionally protected? Yes. Tax-exemption status is completely at the discretion of the United States Congress and can be expanded, modified, curtailed or revoked by an act of Congress. The last sweeping changes to tax exemption rules was the Tax Reform Act of 1986, which introduced the arbitrage and rebate rules and significantly reduced the types of debt that qualified for tax-exempt status. Do I need to do a bond issue that is sold to the public? Why not a bank loan? A bank loan may well indeed be a viable financing option for a prospective issuer. In particular, banks may be excellent options for smaller, shorter termed issues. Public offerings may work better for larger and longer termed issue. Debt may also be privately placed with a limited number of qualified investors. What is the difference between a competitive bid sale and a negotiated sale in a publicly offered issue? In negotiated sales, the issuer engages the bond underwriter prior to the bond sale. The underwriter usually does (or assists in) the structuring and analytical work for the bond issue, and then, during the sale, the underwriter underwrites and sells the bonds as well. In a competitive bid sale, the issuer engages a financial consultant to structure the bonds and provide pre-issue analysis and advice. The bonds are then sold to the lowest bidding underwriter at an advertised bid opening. The two sale methods involve different processes, but both have similar sales results. What official actions must the issuer s governing body take on a bond election and sale? There are two primary actions: Adopt a resolution or ordinance authorizing the election and ballot title, if required, and Adopt a resolution or ordinance authorizing issuance of the bonds after an election How much the governing body participates in the details of the process outside these actions varies by issuer. Typically the governing body is more involved in determining the projects and the size of the bond than in the subsequent details of the bond issuance process. Can we sell our bonds to members of our own community? Our local brokers want some of the bonds to sell. An issuer can direct its underwriter to give preferential treatment to investors from within the issuer s boundaries. To do this, the issuer must use a negotiated sale so that the issuer retains control over the actions of its underwriters. Local brokerage offices can be good sources of sales to retail customers and can be included in the sale as selling group members. (See Chapter 2, Roles and Responsibilities of Principal 8 Chapter 1 Overview of Debt Financing