LAST YEAR, the basics of leasing for state and local governmental entities (“SLGs”) were discussed in the article Municipal Lease 101: A Primer on the Basics, by Dominic Liberatore and Alyse White Hayes (in the July/Aug/Sept 2021 issue of this magazine). That article reviewed frequently raised issues with regard to SLG municipal lease agreements (“Muni-Leases”) and provided practical suggestions to address them. This article will continue the discussion by taking a closer look at the types of termination risks and ways of mitigating those risks from a credit underwriting perspective.
Notwithstanding the ability of the SLG to terminate, the transaction will receive revenue recognition, in part, given that a Muni-Lease obligation in each fiscal year is absolute, unconditional and non-cancelable, except following non-appropriation. Special attention should be paid to specific local contract formation requirements, such as state-specific statutory authority to enter into a “lease,” or a requirement to obtain approval from another governing body, such as a County Commission in the case of a county school board or state bonding authority.
Termination for Convenience. A “T for C,” as it is sometimes called, authorizes an SLG to terminate a Muni-Lease for any reason, or no reason, at any time (i.e., for “the convenience of the government”). Importantly, although the right to “T for C” is found in many federal and some state contracts, this type of provision is not appropriate for a Muni-Lease as it negates the “hell or high water” nature of the obligation and subjects the lessor to the risk of losing its investment and potential recharacterization of revenue recognition. In fact, a “T for C” cannot be included in a tax-exempt Muni-Lease because it violates IRS Tax Code requirements. Therefore, a Muni-Lease containing such a provision should generally be avoided.
Non-appropriation. As noted above, the law typically requires that an SLG have the ability to terminate a Muni-Lease by not appropriating funds to continue to make payments under the Muni-Lease. This right must be a free exercise and there can be no compulsion to appropriate, such as economic or moral influences. The financial position of the SLG or rationale for non-appropriation are of no consequence - the SLG can non-appropriate because the “Sky is Blue.” Any attempt to restrict an SLG’s right to freely exercise the non-appropriation clause will likely be scrutinized by the courts.
One example of such a restriction is a non-substitution clause, which attempts to dissuade an SLG from exercising a non-appropriation clause by prohibiting the acquisition of similar equipment after such non-appropriation event. An example of this provision provides that the SLG: “. . . must certify that the equipment subject to non-appropriation is not being replaced by equipment performing similar functions during the ensuing fiscal year.” Some courts have held non-substitution clauses to be overly restrictive of an SLG’s ability to freely exercise the non-appropriation clause, and/or contrary to a municipality’s obligations to its citizens. As a result, most lessors have removed the non-substitution clause from their Muni-Leases.
Credit review of SLGs is subject to the same standards applied to commercial entities, such as assessment of credit agency reports, financial statement analysis, and collateral evaluation. In addition to these traditional financial underwriting standards, bond ratings (insured and underlying) and local demographic information (such as trends in population, economic growth and tax base) should be considered when evaluating an SLG’s credit. The credit review should also consider whether the SLG has previously exercised a non-appropriation right.
Essential Use Analysis
To mitigate the risk of non-appropriation, it is important to analyze and understand how the related equipment will be used by the SLG in exercising its essential government function. There is a direct inverse relationship between how equipment is used (and in what context) and the risk of non-appropriation. The more an SLG relies on the equipment to achieve its essential obligations, the less likely the SLG will non-appropriate funds for the Muni-Lease, thus lowering the termination risk. If a budget crisis were to occur, the lease of equipment used for an essential governmental function of the SLG is less likely to be terminated than a Muni-Lease comprised of non-essential equipment. This is called an essential use analysis.
This analysis is comprised of two components, the service the SLG provides and the use of the equipment. Certain services provided by an SLG, such as police, fire protection and education, are considered very essential. Others, however—like recreational services, libraries and transportation—have varying degrees of essentiality. Similarly, how the leased equipment is used is viewed through a similar lens of essentiality: equipment the SLG needs to perform its essential governmental functions (e.g., a fire truck used for fire protection or computer equipment used for student instruction) are considered critical, while social services equipment (e.g., playground equipment or buses used to transport senior citizens to social activities), though important, are not considered as critical. Thus, any essential use analysis must consider both the nature of the service and use of the equipment to provide guidance on the credit decision.
Misnomer of Third-party Funding
The repayment obligation under a Muni-Lease is the obligation of the SLG and not conditioned on the SLG’s receipt of funding from a third-party source (e.g., funding for a special initiative from a state to an independent school district or funding from the Department of Justice to a local police department). An SLG may decide to enter into a Muni-Lease based on the availability of certain third-party funding programs, and even decide to non-appropriate if funding is cut off. However, in underwriting such a transaction, third-party funding should not be relied upon too greatly as a source of revenue for repayment or as a specific justification for credit approval.
Introduction
A Muni-Lease is a form of financing used by SLGs to acquire equipment or to undertake capital improvement projects. The Muni-Lease is a cost-effective financing alternative to issuing bonds, as it has lower issuance costs and less administrative entanglements. Generally, there are two types of Muni-Leases: tax-exempt and taxable. Using a tax-exempt Muni-Lease, the interest earnings derived from the transaction will be exempt from the lessor’s federal income taxes (assuming, of course, the Muni-Lease complies with the applicable requirements of the IRS Tax Code, including automatic transfer of title or nominal purchase option at the end of the Muni-Lease term). A taxable Muni-Lease does not provide the same tax benefits and is typically structured with end of term provisions, such as automatic renewal, return or purchase at fair market value. Regardless of whether a tax-exempt or taxable Muni-Lease is used, the SLG must comply with state law, specifically ensuring the transaction does not run afoul of state-specific constitutional or statutory debt issuance requirements and otherwise is structured as a valid obligation of the SLG.Contract Formation Under State Law
To ensure compliance with state-specific debt issuance requirements, virtually all Muni-Leases contain a non-appropriations clause—this ensures the Muni-Lease is not deemed to be “an instrument of debt.” If it is deemed to be an instrument of debt, it could result in the Muni-Lease being deemed void or voidable, which might require the return by the lessor to the SLG of some (or all) payments made under the Muni-Lease. Typically, a non-appropriations clause is structured with a series of annual obligations from a multi-year lease term that permits the SLG’s governing body not to appropriate funds for the next fiscal year. If funding is not appropriated, the SLG may terminate the Muni-Lease at the end of the then-current fiscal year.Notwithstanding the ability of the SLG to terminate, the transaction will receive revenue recognition, in part, given that a Muni-Lease obligation in each fiscal year is absolute, unconditional and non-cancelable, except following non-appropriation. Special attention should be paid to specific local contract formation requirements, such as state-specific statutory authority to enter into a “lease,” or a requirement to obtain approval from another governing body, such as a County Commission in the case of a county school board or state bonding authority.
Types of Termination Risks
Default. Similar to credit risk associated with commercial transactions, this is the risk that an SLG will breach a contractual provision of the Muni-Lease or fail to pay required payments. Enforcement of a default remedy will typically be limited to payments owed during the then-current budget year and return of the equipment.Termination for Convenience. A “T for C,” as it is sometimes called, authorizes an SLG to terminate a Muni-Lease for any reason, or no reason, at any time (i.e., for “the convenience of the government”). Importantly, although the right to “T for C” is found in many federal and some state contracts, this type of provision is not appropriate for a Muni-Lease as it negates the “hell or high water” nature of the obligation and subjects the lessor to the risk of losing its investment and potential recharacterization of revenue recognition. In fact, a “T for C” cannot be included in a tax-exempt Muni-Lease because it violates IRS Tax Code requirements. Therefore, a Muni-Lease containing such a provision should generally be avoided.
Non-appropriation. As noted above, the law typically requires that an SLG have the ability to terminate a Muni-Lease by not appropriating funds to continue to make payments under the Muni-Lease. This right must be a free exercise and there can be no compulsion to appropriate, such as economic or moral influences. The financial position of the SLG or rationale for non-appropriation are of no consequence - the SLG can non-appropriate because the “Sky is Blue.” Any attempt to restrict an SLG’s right to freely exercise the non-appropriation clause will likely be scrutinized by the courts.
One example of such a restriction is a non-substitution clause, which attempts to dissuade an SLG from exercising a non-appropriation clause by prohibiting the acquisition of similar equipment after such non-appropriation event. An example of this provision provides that the SLG: “. . . must certify that the equipment subject to non-appropriation is not being replaced by equipment performing similar functions during the ensuing fiscal year.” Some courts have held non-substitution clauses to be overly restrictive of an SLG’s ability to freely exercise the non-appropriation clause, and/or contrary to a municipality’s obligations to its citizens. As a result, most lessors have removed the non-substitution clause from their Muni-Leases.
Underwriting the Risk of Non-Appropriation
Financial and CollateralCredit review of SLGs is subject to the same standards applied to commercial entities, such as assessment of credit agency reports, financial statement analysis, and collateral evaluation. In addition to these traditional financial underwriting standards, bond ratings (insured and underlying) and local demographic information (such as trends in population, economic growth and tax base) should be considered when evaluating an SLG’s credit. The credit review should also consider whether the SLG has previously exercised a non-appropriation right.
Essential Use Analysis
To mitigate the risk of non-appropriation, it is important to analyze and understand how the related equipment will be used by the SLG in exercising its essential government function. There is a direct inverse relationship between how equipment is used (and in what context) and the risk of non-appropriation. The more an SLG relies on the equipment to achieve its essential obligations, the less likely the SLG will non-appropriate funds for the Muni-Lease, thus lowering the termination risk. If a budget crisis were to occur, the lease of equipment used for an essential governmental function of the SLG is less likely to be terminated than a Muni-Lease comprised of non-essential equipment. This is called an essential use analysis.
This analysis is comprised of two components, the service the SLG provides and the use of the equipment. Certain services provided by an SLG, such as police, fire protection and education, are considered very essential. Others, however—like recreational services, libraries and transportation—have varying degrees of essentiality. Similarly, how the leased equipment is used is viewed through a similar lens of essentiality: equipment the SLG needs to perform its essential governmental functions (e.g., a fire truck used for fire protection or computer equipment used for student instruction) are considered critical, while social services equipment (e.g., playground equipment or buses used to transport senior citizens to social activities), though important, are not considered as critical. Thus, any essential use analysis must consider both the nature of the service and use of the equipment to provide guidance on the credit decision.
Misnomer of Third-party Funding
The repayment obligation under a Muni-Lease is the obligation of the SLG and not conditioned on the SLG’s receipt of funding from a third-party source (e.g., funding for a special initiative from a state to an independent school district or funding from the Department of Justice to a local police department). An SLG may decide to enter into a Muni-Lease based on the availability of certain third-party funding programs, and even decide to non-appropriate if funding is cut off. However, in underwriting such a transaction, third-party funding should not be relied upon too greatly as a source of revenue for repayment or as a specific justification for credit approval.
Closing Thoughts
A Muni-Lease can be an effective tool for an SLG to leverage its funding into a cost-effective form of finance to acquire essential equipment. However, the transaction must comply with various state-specific contract formation requirements, and inclusion of a non-appropriation clause is critical. At first glance, inclusion of a non-appropriation clause may appear daunting to a lessor. However, a thorough essential use analysis may provide a lessor comfort that the Muni-Lease is a risk worth taking.
Share:
Article Tags:
EL&F magazine article
LEGAL RESOURCES
Leasing Law
Column
2022