Municipal financings are often perceived as a very complex, and even overwhelming, undertaking. The various rules and regulations which govern the process oftentimes seem complicated and difficult to understand. Keep in mind that no matter how difficult or cumbersome the process may seem, the issuance of bonds or notes by a municipality is simply the mechanism through which it borrows money. The following five points outline some of the basics that all municipal officials should know when considering the issuance of bonds or notes.
DEFINE THE PURPOSE OF THE BORROWING
A municipality issues bonds or notes to borrow money. And, unlike most borrowers in the private sector, it may borrow money on a tax-exempt basis. That is, if properly structured, municipal bonds or notes carry a federal income tax-exemption on the interest earned on the bonds or notes; and therefore, investors will buy tax-exempt municipal bonds or notes at a lower interest rate than taxable bonds. As a result, the municipal issuer will pay a lower interest rate on the money it borrows.
As implied by the above, issuing bonds or notes on a tax-exempt basis requires any such borrowing to be in compliance with the Internal Revenue Code of 1986 (the “Code”) and the various regulations promulgated thereunder. Compliance with the Code and its regulations drives much of what is undertaken when issuing bonds or notes, including the nature of the projects which may be financed with tax-exempt bond or note proceeds.
Generally speaking, a municipality may issue debt to (i) finance capital projects, such as the construction of governmental offices, the renovation of road systems, or the purchase of fire trucks, and (ii) to refinance existing debt. A municipality refinances debt for the same reason that one would refinance a mortgage – to take advantage of lower interest rates in order to achieve savings over the length of the borrowing. Under certain circumstances, a municipality may also undertake short-term borrowings in anticipation of tax and other revenues (known as tax and revenue anticipation notes or bonds), to ensure the consistent operation of the municipality in those instances when tax and other revenue streams may vary month-to-month.
CONSIDER TIMING AND STRUCTURE
When undertaking a tax-exempt financing, a municipality must consider (i) when it will require the bond or note proceeds to undertake its desired project, (ii) the timing of the financing, that is, how long it will take to complete the borrowing to access the funds; (iii) the interest rate environment at the time of the borrowing, or market conditions, and (iv) the public support for the project being financed. In short, the municipality must “time” the financing as best it can to access the lowest interest rates at the time the money is needed to undertake the project, taking into consideration the public support for the project.
Critical to the timing consideration is the determination of the approach the municipality desires to undertake in financing the project. Generally speaking, a municipality may undertake the financing by issuing bonds or notes through the capital markets, often referred to as a public offering. Or, the municipality may issue a bond or note for purchase by a bank or other lending institution. Either approach includes within it other structural considerations or options, all of which should be determined in conjunction with the decision to borrow money, and certain of those determinations may impact the timing of the borrowing.
RETAIN THE APPROPRIATE PROFESSIONALS
To that end, and having determined to undertake a borrowing through the issuance of municipal bonds or notes, it’s important to retain the appropriate professionals early in the finance process to assist the municipality as it navigates through the financing. Below is a list of professionals often retained in a municipal financing, and the roles each may play:
Financial Advisor – Although not required, a municipality may choose to retain a financial advisor to assist it in undertaking the decision to borrow money and the timing of such decision, to determine the finance structure, to identify appropriate professionals, and to “quarterback” the finance process. The Financial Advisor can work with the municipality to develop a preferred “repayment schedule” for the money to be borrowed, taking into consideration the budgeting needs of the municipality and the municipality’s tax and revenue stream. Additionally, the Financial Advisor can assist the municipality in developing “requests for proposals” for the selection of a bank, should the municipality determine to privately place its bond or note, and for the selection of other professionals to the financing.
Underwriter – An Underwriter is only required should the municipality choose to access the capital markets to borrow money, that is, to undertake a public sale of its bonds or notes.
The Underwriter may be selected through a competitive sale or negotiated process. In a competitive sale process, a variety of underwriters submit bids to the municipality and the bonds are awarded to the Underwriter that offers to pay the municipality the lowest interest cost. Or, the Underwriter may be selected in a negotiated transaction, where the municipality hires the Underwriter at the beginning of the finance process, and the Underwriter helps find investors for the bonds or notes. If the municipality chooses an Underwriter through a negotiated process, the Underwriter may undertake many of the duties undertaken by a Financial Advisor: it will assist in the development of the plan of finance, assist in the development of the structure, and assist in determining the timing of the sell of the bonds or notes based on market conditions, among other things. It should be noted, however, that while an Underwriter has a duty to deal fairly with the municipality, it does not have a fiduciary duty to act in the best interests of the municipality, such as a Financial Advisor. The Underwriter’s primary role in the transaction remains purchasing the municipality’s securities with an aim toward distribution, and therefore its interests may at times conflict with the municipality.
Bond Counsel – Bond Counsel should be retained very early in the finance process. Bond Counsel, like the municipality’s solicitor, represents the municipality as the issuer of the bonds or notes. Bond Counsel provides guidance in structuring issues related to tax law; reviews applicable law to confirm the municipality’s authority to issue the bonds or notes and its conformity with legal requirements, including the Local Government Unit Debt Act; drafts the applicable ordinance and other finance documents; and renders its legal opinion regarding the tax-exempt status of the bonds or notes.
Of course, and in addition to the professionals unique to the municipal finance process, the municipality’s solicitor works closely with the municipality and with bond counsel to ensure that all of the municipality’s legal requirements are met.
REMEMBER THE LOCAL GOVERNMENT UNIT DEBT
In structuring a bond or note financing, the municipality’s professionals must not only consider tax law and securities law requirements (as applicable in the context of a public offering), they must also consider all state law requirements. In Pennsylvania, a municipality may not incur debt without being in compliance with the Local Government Unit Debt Act (or LGUDA). That is, a municipality may not “transfer” the bond or note to a purchaser without demonstrating, among other things, that the anticipated borrowing, together with any other outstanding debt of the municipality, will not cause the municipality to exceed its statutorily prescribed debt limits, as determined by LGUDA.
While most municipalities recognize the debt limitations as set forth in LGUDA, many overlook that LGUDA also sets forth requirements which directly affect the structure of a municipality’s financing, the length of any borrowing, the repayment schedule, and the purposes for which a municipality may finance or refinance any project. All of these factors are considered in the LGUDA approval process.
The LGUDA approval process is a complex and critical component when considering the timing of any financing. The approval process may become more complex this year if recent proposed amendments to LGUDA are enacted. On February 1, Senator Mike Folmer (R-Lebanon) introduced a series of bills to reform perceived shortcomings in LGUDA as it currently exists. Of interest to municipalities are proposed changes to the LGUDAapproval process, which, if enacted, would require all municipalities to obtain preliminary approval for a debt issuance before commencing a financing. The preliminary approval requirement would be in addition to the existing LGUDA approval requirements.
THE WORK ISN’T FINISHED AFTER THE BONDS OR NOTES ARE ISSUED
The Internal Revenue Service (“IRS”) now strongly recommends that any issuer of tax-exempt debt, including a municipality, have in place certain “post issuance compliance policies,” designed to ensure that the municipality maintains the tax-exempt status of the bonds or notes issued through the maturity date (or earlier prepayment) of such bonds or notes. In fact, the Form 8038G, completed by Bond Counsel at the time of a tax-exempt financing, and executed by the municipality at the closing for such bonds or notes, specifically inquires as to whether the municipality has such post issuance compliance policies in place. Bond Counsel, and the municipality’s solicitor, can assist a municipality in the drafting of a post issuance compliance policy that (i) complies with the recent guidance suggested by the IRS, and (ii) works well with the municipality’s existing practices and procedures.
Should the municipality determine to issue its bonds or notes through a public financing, the municipality will need to take certain steps to keep their investors informed, at the time of issuance and afterward. The municipality will be required to provide on an annual basis its audited financial statements and such other finance documents as determined at the time of the financing. In addition, the municipality will have the obligation to discuss certain events, as listed in a continuing disclosure certificate or agreement the municipality will execute at the time of the closing for the bonds or notes.