Municipal Leasing 101:: A Primer on the Basics

THIS ARTICLE WILL DISCUSS some key take-aways for leasing (“Muni Leasing”) to state and local governmental entities (“SLGs”). No one size fits all for the 50 states. Sometimes even within a state there are variations. However, there are also many commonalities. The following is a primer on some frequently raised issues and some practical suggestions to address them. 

Opening Caveats 

Many organizations lump other areas into their governmental groups. This article will focus only on leasing to state and local governmental entities, not leasing to Federal governmental entities, not-for-profit entities or Native American Tribes. 

Aside from the common issues discussed below, funders need to be aware that some states have very strict requirements. Failure to comply with these requirements can render a lease unenforceable or otherwise materially impact a funder’s rights thereunder. To name just a few: 1) Georgia has certain strict term limits; 2) California has specific signing authority limits for cities within California and 3) Florida has security interest grant limits. It is critical to know local law or retain local counsel who does. Requirements such as the above (and many others) are not intuitive. In Muni Leasing, funders therefore require opinions of counsel from SLGs more frequently than when leasing to commercial entities. 

COMMON MUNI LEASING ISSUES: 

Basics of non-appropriation - Generally speaking, Muni Leasing funders employ “hell or high water” leases that may not be cancelled or terminated. However, typically the Muni Lease must include a limited right to terminate an otherwise non-cancellable lease in the event of “non-appropriation” (described further below). Failure to include this right (even if not requested by the SLG) may cause the lease to constitute an invalid or unconstitutional “debt” under applicable law. 

In order for an SLG to lawfully enter into a lease and obligate itself to make lease payments, it must have appropriated funds in its budget for such payments. Budgets are done annually and the SLG will represent and warrant that for the SLG’s then current fiscal year sufficient funds have been appropriated to make the lease payments. It is expected that the SLG will continue to cause sufficient funds to be appropriated for subsequent fiscal years for the SLG’s obligations for the full term of the lease. 

While it may seem like an SLG could on a whim elect to terminate a lease by way of non-appropriation (referred to as “non-appropriating”), this is not the case. An SLG is generally not entitled to choose to non-appropriate simply because it found a better deal elsewhere, or because it no longer wants the equipment. Further, electing to non-appropriate may also impair the SLG’s ability to secure future financing from such funder and, potentially, other funders. Non-appropriation may also have a negative impact on the SLG’s bond rating.

Indemnification - Another sensitive issue for SLGs involves including an otherwise industry standard indemnity clause protecting the funder against losses or damages caused by the equipment. Unless such clause is (i) qualified by adding a phrase such as “to the extent permitted by applicable law,” or (ii) modified by providing that the SLG will seek to obtain appropriations annually to make such payments rather than an unconditional agreement of the SLG to indemnify the funder, such an indemnity clause may cause a Muni Lease to constitute an invalid or unconstitutional “debt.” Even if not raised by the SLG, this is a very good proactive concept to include. 

Limits on Remedies - The remedies available to a funder under a Muni Lease are also limited from what is traditionally available. Limits on remedies for SLGs arise by statute, regulation and/or the SLG’s right of non-appropriation. While these limits vary by state and municipality, the following three are frequently seen: 

1. SLGs often negotiate the default interest rate to a rate that is set by state or local regulation. This rate is often significantly lower than the standard interest rate for non-SLGs. 
2. In an event of default or termination of a Muni Lease due to non-appropriation, the funder is not able to accelerate amounts owed over the full term of the lease, but rather is only entitled to amounts presently due and owing, and amounts owing for the current fiscal period (in addition to the return of the equipment). The funder is unable to recover amounts owed beyond the current fiscal period, because those funds have not been appropriated by the SLG’s governing body.
3. A Muni Lease may be subject to certain dispute resolution regulations that require the funder to follow state or local processes and procedures to recover the leased equipment and/or any amounts owed by the SLG. 

Taxes and Tax Exemption Status - One primary advantage to both the funder and the SLG relates to the tax benefits available in Muni Leasing. If the Muni Lease meets all the tax-exemption requirements of the IRS Tax Code, the interest income generated to the funder from such lease will be exempt from federal income tax. In order to meet those requirements, the lessee must be an SLG; the lease-purchase obligation must be incurred under the SLG’s “borrowing power” and contain a separately stated interest component; the lease must be structured as an installment sale (i.e., $1 Out) and not a true lease; and it must meet all other requirements of IRC §§ 103, 141-150. Ultimately, this tax exemption benefit can result in an overall lower cost of funds for the funder and, thereby, a better borrowing rate for the SLG. 

Additionally, a Muni Lease is generally exempt from property taxes by virtue of the SLG’s tax-exempt status, and its ownership of the equipment under a Muni Lease. Note though that the exemption from property taxes may sometimes also be determined by the county in which the SLG is located and therefore this may require further due diligence. 

Last, sales tax exemptions are governed by state law and funders must look to each SLG’s state regulations to determine if the Muni Lease is also exempt from sales tax. 

Governing Law and Jurisdiction - SLGs will invariably insist that the Muni Lease provides for use of their own state’s law and jurisdiction. If a funder is doing business with an SLG in a given state, using such state’s law and jurisdiction is inherently part of doing such business. It is generally not a negotiation a funder can win, either because the SLG will articulate that local law or administrative regulation requires this or simply because it will not agree otherwise. This is one point that is best conceded early on before moving to the next point. 

Apparent Authority - The type of authorization needed for Muni Leasing varies by state. Generally, the governing body of the SLG should adopt a resolution or authorization or take other formal action to authorize the Muni Lease. Unlike commercial leasing, where apparent authority is frequently relied upon, a funder should not rely on apparent authority for Muni Leasing and instead should require a legal opinion if the amount to be funded is in excess of a minimum threshold set by the funder. 

Conclusion

Muni Leasing is an important and valuable part of the equipment finance industry. Although there are many local law variations (some of which are material) that all funders must take into account, there are also many common issues. Knowledge of local law and the basics are keys to successful Muni Leasing programs.