This article is reproduced in The Tax Exempt Leasing Letter with permission of Standard & Poor’s Ratings Services, a division of The McGraw-Hill Companies, Inc. - “Revised Lease and Appropriation-Backed Debt ”, by Colleen Woodell and Richard Marino, dated June 13, 2001 - Further reproduction or distribution is prohibited without the express written consent of Standard & Poor’s Ratings Services.

The data gathered in the preparation of Standard & Poor’s “Municipal Rating Transitions and Defaults” study indicates that lease and appropriation debt rated by and meeting legal requirements tracks precisely with the obligor’s long term rating. As a result, the ratings on these obligations will now be more a reflection of the obligor’s general credit and focus on project detail will be reduced. The traditional multiple notching off the general obligation rating will be eliminated and lease and appropriation obligations that meet our legal criteria will be rated one notch off the general obligation ratings, effectively eliminating the historic reliance on essentiality as a credit factor. Although reduced in magnitude, notching will continue, as a reflection that leases and appropriation obligations are not legally debt and do not bear the same legal protections as general obligation bonds.

This change applies only to capital obligations, not operating or vendor obligations.

This decision reflects:

• The maturation of the appropriation-backed market;
• The comparable low risk of default between general obligation bonds and appropriation-backed debt;
• The long history of appropriation-backed financing by state and local governments; and
• The significant incorporation of contractual debt within the capital plans for state and local governments.

Last year, Standard & Poor’s raised the ratings on nine states’ contractual dependent ratings to one notch below the obligor’s GO rating for similar reasons. That decision laid the groundwork for today’s action.

Standard & Poor’s has been rating appropriation-backed debt for more than two decades. Over that time, we have seen a greater acceptance of this form of debt within the public markets. Once confined to a limited number of municipal governments in California, this type of debt issuance is now common in at least 33 states. Over the last 20 years, the occurrence of a default on appropriation-backed debt has been similar to the default rate of general obligation bonds. The default risk is low for both types of debt issuance and the significant difference in credit risk identified by a rating differentiation of one full category no longer accurately reflects the minimal difference in default risk. Standard & Poor’s has also seen appropriation-backed contracts become a critical component of both state and local governments’ capital infrastructure programs, in some instances making up over 50% of the capital program. Furthermore, state and local government managements understand the capital markets and obligations under these programs. Finally, while appropriation-backed bonds are not considered debt under a strict legal definition, Standard & Poor’s considers all appropriation-backed bonds of an issuer to be an obligation of that issuer and a failure to appropriate will result in a significant credit deterioration for all types of debt issued by the defaulting government.

Criteria Changes

Standard & Poor’s criteria for evaluating the legal structure, cited below, will remain the same. However, there are three areas of Standard & Poor’s criteria that, as a result of this decision, will change.

Essentiality
Evaluation of the essentiality of a particular project and the willingness to pay for that project is a part of the analysis performed in the assessment of the general creditworthiness of the issuing government and will not be the basis for a distinction in the assignment of a contractual debt rating. The decision as to what type of debt to issue to fund a government’s capital plan is secondary to the types of projects that government has chosen to enter into. As such, the evaluation of a government’s capital program incorporates both the need for a particular project as well as the government’s ability to provide for the payment of any debt associated with that debt issuance. If a state or local government enters into a proportionately large amount of projects that are controversial or are designed to promote economic development while ignoring the basic service delivery needs of that government, that decision will be reflected in the general creditworthiness of the issuer and not only in the assessment of a rating for a particular debt issue.

Security interest
The second area of change is in the provision of a security interest in the financed project. Security interest is a common lease feature, in which the governmental lessee grants the lessor--or the trustee, as assignee of the lessor--title or a first lien on the leased property for the life of the bonds. In the event the lessee chooses to exercise its right of nonappropriation, the lessor, or its assignee, has the right to take possession of the leased asset. For many projects, even if a security interest is granted, it is questionable as to whether the lessor or its assignee can effectively take possession of the projects, as in the case of a prison, a government center, a school or any other facility which serves the basic functions of that government. Therefore, a security interest in those projects, which Standard & Poor’s considers to be used for a basic government function, will no longer be required. However, for those projects that do not meet this definition, Standard & Poor’s will evaluate the transaction within the context of that state’s laws and the government’s specific circumstances, but this feature should be included if it is available.

General creditworthiness
Finally, since all appropriation-backed debt will now be rated one notch below the obligor’s general creditworthiness, the evaluation will shift from a particular project financing to the overall assessment of the general creditworthiness of the government itself.

Rating Considerations

To rate a lease transaction requiring annual appropriations, Standard & Poor’s evaluates the following:

Lessee general creditworthiness
The government obligor’s general creditworthiness evaluation is based on traditional general obligation analysis and includes factors such as:

• Overall debt structure and burden,
• Economic and tax-base factors,
• Financial flexibility, performance, and position, and
• Administrative and management factors.

If the government obligor were a utility district, university, hospital, or other not-for-profit entity, the relevant rating criteria used in assessing credit quality for those types of entities would be applied. Please refer to Standard & Poor’s Public Finance Criteria for more detail.

Security features
The history of legislative authorizations for lease financings, prior leasing experience, and the intent of the lessee—indicated, for example, by an equity interest in the leased property—are important in determining lease ratings. However, these factors are not substitutes for adequate legal protections. In some states, because of constitutional or statutory limitations, lease-secured debt is the only practical financing option.

Appropriation and term features
For leases where the commencement of rentals depends on successful completion or acceptance of the property being financed, the rating is “provisional.” For a master lease, when the lessee uses one lease agreement for multiple leased properties, Standard & Poor’s requests that the acceptance and effective date of lease payments be tied to the receipt of the major lease component.

For state-level master leases, where numerous operating departments may be involved, a centralized appropriations process helps to ensure the timely payment of obligations.

The following appropriation features are important to the evaluation of the transaction’s structure:

• The useful life of the leased property or project matches or exceeds the term of the lease contract.
• The term of the lease contract matches the term of the bond issue or certificates of participation, avoiding exposure on renegotiation; if state law prohibits long-term leases, term renewal should be automatic.
• The lease payments represent installments toward an equity buildup in the leased property. At the end of the lease and debt terms, ownership of the asset should transfer to the lessee automatically or for a nominal fee.
• The lessee agrees to request appropriations for lease payments in its annual budget.
• The lessee unconditionally agrees to make rental or purchase option payments as agreed. Such payments should not be subject to counterclaim or offset as a result of a disagreement over any aspect of the transaction. A clear statement that “notwithstanding any other provisions to the contrary, lease rental payments are triple-net not subject to counterclaim or offset” should be included in the lease contract.

For California lessees, the lessee covenants to appropriate lease payments, subject to abatement in the event the leased property is not available for use. Although Standard & Poor’s also rates annual appropriation-style leases for California issuers, abatement leases are viewed favorably for their accruing characteristics.

Central approval and oversight
In some states, there is strong oversight by the state of local entities’ debt issuance and budgeting practices, which extends to lease contracts. This oversight is considered a positive in the overall evaluation of the general creditworthiness of the government.

Underlying revenues in support of appropriation-backed securities
In certain circumstances, a government may legally pledge specific tax revenues to meet its lease payment obligation. If the pledged revenues are not available for any purpose other than those consistent with the appropriation project, such as economic development or a convention center, the appropriation risk is significantly mitigated.

Maintenance and insurance
The lessee should agree to maintain the leased property in good repair and to insure it against loss or damage in an amount at least equal to the purchase option value or replacement cost, if repair and replacement are mandated by the lease agreement. If lease payments are subject to abatement in the event the property is damaged, destroyed, or taken under a provision of eminent domain, the lessee must maintain business interruption insurance. Where applicable, special hazard insurance coverage is required unless the leased facility passes Standard & Poor’s natural hazard test.
Self-insurance for property damage risks is permitted. Adequate reserve levels must be maintained and reviewed annually by an independent consultant or professional risk manager. Annual notification to the trustee that reserve levels are adequate must be made. Self insurance is not an acceptable alternative to commercial coverage for earthquake risk when the lessee’s obligation is limited only to self-insurance reserves and does not extend to the municipality’s general resources.

Debt service reserve fund
A debt service reserve equal to maximum semiannual debt service or six months advanced (and unconditional) funding of debt service, or an equivalent combination of reserves and advance funding, may be required. This applies to leases that provide for abatement for lost use of property owing to damage or destruction or to leases where late budget passage risk exists.

Lessor features and bankruptcy risk
Most lease transactions rated by Standard & Poor’s are between a governmental lessee and a non-profit public benefit corporation, as lessor, which has been established specifically for the purposes of the lease transaction. These lessors, typically, are filers under Chapter 9 of the U.S. Bankruptcy Code and are considered to be bankruptcy remote.

For lessors not judged to be bankruptcy remote, there must be a sale and absolute assignment by the lessor of lease rental payments to the trustee, thereby ensuring timely payment to the bondholders if the lessor becomes insolvent. The assignment should be accompanied by a legal opinion stating that as a result of the assignment, bankruptcy of the lessor would not cause the lease and lease payments to be considered property of the lessor’s estate. The automatic stay provisions of the Bankruptcy Code should not apply and therefore would not cause an interruption of rental payments to the bond trustee.

Insolvency-proofing the lessor is an alternative approach. The lessor should be set up as a single-purpose entity (SPE) that is prohibited from engaging in any business—other than owning the rated project—and from incurring additional debt, unless it is rated at least as high as the Standard & Poor’s rated lease-secured debt. Furthermore, the SPE may not sell the project except to another entity that meets these criteria unless the entity’s senior debt is rated by Standard & Poor’s at least as high as the lease obligation. These provisions should appear in the lessor’s partnership agreement or articles of incorporation and in the trust indenture.