Partial Acceleration in a Non-Acceleration World – Term Outs and Puts in California Certificates of Participation

September 12, 2013

As long as certificates of participation (COPs) remain an important financing tool for California public entity issuers, municipal lenders, such as banks, will continue to provide credit and/or liquidity support for variable rate COPs or will purchase COPs in direct purchase transactions. Municipal lenders generally are not in the business of extending credit or holding securities for long periods of time. Rather, municipal lenders desire to provide credit and/or liquidity support for commitment periods (or, in the case of direct-purchase transactions, initial periods) ranging from one to five years and, unless the commitment (or initial) period is extended, municipal lenders then want to be repaid as soon as possible, typically over a three- to five-year term-out period. While the desire to be repaid as soon as possible creates a tension in almost all municipal financings, it creates particular problems in California COPs transactions.

California prohibits most public entities from incurring debt payable over a multiyear period without first obtaining super majority voter approval. There are a number of exceptions and qualifications to this general prohibition. One such exception, the “lease” exception, has evolved through case law, the most prominent of which cases are City of Los Angeles v. Offner (1942) 19 Cal.2d 483 and Dean v. Kuchel (1950) 35 Cal.2d 444. Relying on this lease exception, public entities in California lease property to a special purpose entity (often a nonprofit, public benefit corporation controlled by the public entity or a joint powers authority in which the public entity participates) through a ground or site lease and then lease the property back in exchange for rental payments that serve as a proxy for debt service payments. The Offner-Dean line of cases stands for the proposition that abatement lease obligations, unlike debt, are contingent upon the continued use and/or occupancy of the leased property and do not represent a pledge of future revenues. As such, abatement lease obligations do not require voter approval.

As noted in the California Debt and investment Advisory Commission’s Guidelines for Leases and Certificates of Participation, the most significant and widely accepted aspects of an Offner-Dean abatement lease are: (1) rent is due only during those periods in which beneficial use and/or occupancy of the leased property is available to the lessee; (2) acceleration of rental payments is not permitted; (3) rent is paid from any lawfully available funds of the lessee; (4) the terms and conditions of the lease are similar to those found in a commercial context for a similar type of facility; (5) the lease term should not extend beyond the anticipated useful life of the leased property; and (6) rental payments cannot exceed fair market rental.

If, as the Offner-Dean line of cases posit, rental payments cannot be accelerated, can a municipal lender exit a credit on an accelerated basis?

The answer depends in part on whether the fair rental value of the leased property exceeds the base rental for the leased property and, if so, by how much. Base rental is a known stream of payments that represent debt service on COPs based upon certain interest rate assumptions. Fair rental value of leased property, however, is not defined under California law and is not easily quantified. For the municipal lender this is both good and bad. On the good side, there is room for some degree of subjectivity. On the bad side, there is no certainty that assumptions made at the outset will remain correct over time. Faced with this dilemma, what is the municipal lender to do?

The best answer is to obtain as many inputs as possible. In the nongovernmental world, appraisal would seem to be the obvious starting point. However, appraisal is less useful in the governmental world given the unique nature of many leased governmental properties (e.g., how do you value a fire station?). In addition, appraisals are normally outsourced and the cost of the appraisal would need to be included in the municipal lender’s bid, which may adversely impact the attractiveness of the bid. Consequently, the starting point is usually the issuer’s real estate department (i.e., what value does the issuer attribute to the leased property on its own books?). Depending upon the type of property, insured replacement value also may be a good proxy for value. The municipal lender should also consider whether the leased property is of a type that could readily be used for a different purpose. If a property can be used for a purpose other than a governmental purpose (e.g., a governmental office building could be used as a commercial office building), the municipal lender may wish to consider value on a best-use basis.

Armed with fair rental value information, the municipal lender can now assess whether the anticipated fair rental value exceeds base rental value and, if so, by how much. The excess (if any) will support accelerated payments to the municipal lender once the loan is in term-out mode, assuming that fair rental value does not decline over the course of the financing. By raising rental from base rental to maximum fair rental in the underlying financing documents, greater payments can be directed to the loan or securities held by the municipal lender. This will result in partial acceleration when compared to debt service on the underlying COPs, while at the same time preserving the constitutional debt analysis.

Given that fair rental value can decline over time, most municipal lenders will require the public entity issuer to agree that it will not voluntarily re-determine fair rental value during the term of the financing without the lender’s prior written consent. While most issuers will agree to this type of covenant, insurance valuations routinely undertaken by the issuer may undercut its worth. Conversely, to take advantage of prospective fair rental value increases, most municipal lenders will retain the right during the term-out period to re-determine, or to direct the public entity issuer to re-determine, the fair rental value of the leased property.

Some California issuers are now including a “maximum base rental” concept in their Offner-Dean leases. This concept caps the issuer’s lease payments in the event that fair rental value increases. From the municipal lender’s perspective, a cap on fair rental value should be resisted unless the municipal lender is comfortable that the maximum base rental is sufficient to support the lender’s term-out payments.