What are certificates of participation
CERTIFICATES OF PARTICIPATION
In August 2000, the Santa Barbara County Board of Supervisors (BOS) approved the issuance of $32.99 million in Certificates of Participation (COPs) to build ten new County administrative, public safety, and health-related facilities. This issuance, if completed, will increase the County’s outstanding long-term obligations (as of June 30, 2000) by 65%.
COPs are lease financing agreements in the form of securities that can be marketed to investors in a manner similar to tax exempt debt. Legally, COPs are not considered debt, however, and can therefore be issued by a vote of the BOS rather than requiring a vote of the residents of the County. For this reason, and to encourage public awareness of and knowledge about the proposed issuance, the 2000-2001 Grand Jury believes that a report explaining COPs and the rules by which they are governed is appropriate. This report also describes past usage of COPs in Santa Barbara County and the present proposal.
Historically, COPs have been a financing method, among other things, to monetize existing surplus real estate. If a local government agency (Lessor) did not have a current need for certain facilities, officials had the authority to lease those facilities to a designated non-profit corporation (Trustee) that would in turn sub-lease the facilities to other organizations (Sub-lessees). In order to monetize the facility, Trustees would sell Certificates of Participation in the future sub-lease payments to be received by the corporation. The corporation would then apportion those monies back to the local government agencies.
For projects such as purchasing or constructing new buildings, governmental entities traditionally used long-term bonds, issued with approval of the voters (or, rarely, available cash). In 1978 California voters approved Proposition 13, which, among other things, increased the required voter approval for bond debt from a simple majority to a two-thirds vote, and governments found this increased approval percentage quite difficult to obtain. COPs, not requiring any voter approval, quickly became the financing mechanism of choice.
Since the passage of Proposition 13, the Board of Supervisors has encumbered the citizenry of Santa Barbara County with more than $100 million in long term obligations over the years without voter approval. This has been accomplished through sale-leasebacks of county real estate and equipment financed by COPs rather than bonded indebtedness. As of June 30, 2000, the outstanding COPs debt was $50.695 million. Of this total, $43.414 million is in the general long-term debt account group and $7.28 million is in the Solid Waste Enterprise Fund.
This large debt obligation can be created by a simple majority (3-2) vote of the BOS if COPs are approved during the budget cycle (a 2/3 vote is required if outside the budget).
Voter reluctance to approve bonds by the required 2/3 majority has no doubt contributed to the BOS use of COPs as the primary financing method for capital projects.
DESCRIPTION OF CERTIFICATES OF PARTICIPATION
Certificates of Participation are defined as lease financing agreements in the form of tax exempt securities similar to bonds. In COPs financing, title to a leased asset is assigned by the lessor to a trustee (non-profit corporation) that holds it for the benefit of the investors, the certificate holders. The participation of many investors in the lease transaction allows the transformation of what would otherwise be a straightforward financing instrument executed between a lessee and a lessor into a marketable security. COPs are thus a method of leveraging public assets and borrowing all or a portion of the value of a public agency’s equity in those assets in order to finance other assets. By entering into a tax-exempt lease financing agreement a public agency is using its authority to acquire or dispose of property, rather than its authority to incur debt. This financing technique provides long-term financing through a lease or lease-purchase agreement that legally does not constitute indebtedness under the State constitutional debt limitation. (Despite this, the term "debt" is generally still used in describing the obligation.) It is not subject to other statutory requirements applicable to bonds, including the requirement of a vote of citizens.
The non-profit corporation is the intermediary entity that is created to issue the COPs for sale to investors as marketable securities. This means that the lease enjoys much greater access to funds and creates liquidity for investors. COP-based borrowing makes the certificates marketable and transferable, generally behaving like conventional tax-exempt debt instruments.
A key characteristic of a tax-exempt lease that distinguishes it from bond indebtedness is a nonappropriation clause. The nonappropriation or fiscal funding clause means that payments of the lease are dependent upon an annual appropriation by the governing body. This differentiates the lease from indebtedness because with the nonappropriation provision, the present-year government’s action does not bind succeeding ones to pay the obligation. However, the non-debt classification of lease-purchase financing does not eliminate the need to fund lease payment expenditures nor does it eliminate the responsibility of the government to disclose the obligation in its financial statements.
The general procedure for issuance of a COP is as follows:
- The County identifies the leaseable asset, the
purpose for incurring debt and the amount of debt to be incurred. The County leases or transfers the leaseable asset to a Lessor. The Lessor leases the asset back to the County. The Lessor’s right to receive lease payments are transferred to a Trustee. The Trustee executes Certificates of Participation which are sold to members of the public.
All of the steps in the leaseback arrangement are performed together giving the appearance of one seamless transaction.
Certificates of Participation Language
The following language is on the first page of the most recent issues of County of Santa Barbara Certificates of Participation (earlier issues had substantially the same language):
"NEITHER THE CERTIFICATES NOR THE OBLIGATION OF THE COUNTY TO MAKE BASE RENTAL PAYMENTS CONSTITUTE AN OBLIGATION OF THE COUNTY FOR WHICH THE COUNTY IS OBLIGATED TO LEVY OR PLEDGE ANY FORM OF TAXATION OR FOR WHICH THE COUNTY HAS LEVIED OR PLEDGED ANY FORM OF TAXATION. NEITHER THE CERTIFICATES NOR THE OBLIGATION OF THE COUNTY TO MAKE BASE RENTAL PAYMENTS CONSTITUTE A DEBT OF THE COUNTY, THE STATE OF CALIFORNIA OR ANY OF ITS POLITICAL SUBDIVISIONS WITHIN THE MEANING OF ANY CONSTITUTIONAL OR STATUTORY DEBT LIMITATION OR RESTRICTION."
If the government lessee fails to make the required lease payments, the lessor has the right to take possession of and operate or sell the property without a legal contest.
Budget and Appropriation of Base Rental Payments Language
Language as follows is included in the most recent issues of County of Santa Barbara Certificates of Participation (earlier issues had substantially the same language):
"During the term of the Sublease, the Base Rental Payments for the Demised Premises or such component thereof shall be paid from any source of legally available funds of the County, and so long as the Demised Premises, or such component thereof, is available for the Lessee’s use. The County has covenanted to take such action as may be necessary to include (from all lawfully available money of the County) all Base Rental Payments and Additional Rental (as defined herein) due under the Sublease and all funds necessary or appropriate for the operating and maintenance of the Demised Premises and the administration of the Trust Agreement (including without limitation audit fees, Trustee fees and rebate amounts) in its annual budgets, and to make the necessary appropriations for all such Payments, which covenants of the Lessee shall be deemed to be, and shall be, ministerial duties imposed by law, and it shall be the duty of each and every public official of the County to take such action and do such things as are required by law in the performance of the official duty of such officials to enable the Lessee to carry out and perform such covenants."
In the event the issuer failed to make a lease appropriation under a COPs financing the lessor would assume ownership of the leased equipment or facility and would also be subjected to a potential change in the tax treatment of the obligation. For these reasons investors place great emphasis on the "essentiality" of the leased property. If it is evident that the equipment or facility is essential to the government’s operation, investors feel there is a reduced risk that an event of nonappropriation will occur.
An asset transfer structure for COPs is typically used for two reasons: First, it allows the construction of a project without having to capitalize interest. Second, the project being acquired or constructed may not have a sufficient degree of necessity; encumbering a more essential asset may raise the level of essentiality to allow COP financing.
Some of the stated disadvantages include "dilution of the government’s general resources by encumbering equity in the pledged assets" and "revenue capacity within the current operating budget must be identified." The interest-rate for COPs financing is typically higher than for general obligation bonds. The interest rate differential reflects the added risks of nonappropriation in a lease-purchase financing structure. COPs also require a debt-service reserve fund, typically 10% of the principal, which is not required for general obligation borrowing. Using COPs increases the principal amount borrowed because of the debt service fund.
Other Methods of Financing Projects
The pay-as-you-go method of funding means that capital projects are paid for from the government’s current revenue base or its reserves rather than issuing bonds or COPs and repaying those borrowings over time. The advantage is that interest payments are avoided. For long-term indebtedness interest cost over the life of the debt typically exceeds the amount borrowed. The savings by not having to pay a debt load are substantial. Converting to a pay-as-you-go method rather than issuing bonds or COPs may cause a delay in project implementation, however, if funds have not been set aside. With pay-as-you-go financing it can be extremely difficult to achieve a discipline whereby elected officials will set aside sufficient money for capital purposes.
Long Term Debt Options:
A variety of bond options in addition to COPs are available for funding projects. Examples are shown in the table on the next page.
Bond Options Per Typical ProjectSource: www.sbcgj.org