I’ve already written about the Jefferson County School Board’s decision to default on its Supplemental Pension Plan. It turns out it’s also using something called Certificates of Participation as a loophole to circumvent the State Constitution’s ban on governments issuing general obligation debt without a vote of the people. They’re not alone in this, and it can lead to a significant understatement of a government’s – thus the citizens’ – total indebtedness.
In 2006, the JeffCo School Board voted to offer teachers the option of taking a lump-sum payment for the value of their pension benefit, or to stay in the 10-year payout program. In order to help capitalize the buyout, the Board issued $38.7 million worth of Certificates of Participation (COPs), with maturity dates from 2007 to 2026.
Note that even if the Board succeeds in closing down the Supplemental Retirement Program and discharging itself of about $7.4 million of unfunded obligations, approximately $33.1 million worth of principle on those COPs will remain on the books.
Since the State Constitution prohibits governmental entities from issuing unsecured debt without a vote of the citizens, how is such a this possible?
Keep your eye on the shell with the pea.
Technically, the COPs weren’t issued by the School District, but by a corporation, the Jefferson County School Finance Corporation. Nine school building were leased by the District to the Corporation for some nominal amount, and then leased back to the District by the Corporation. The lease payments by the District to the Corporation are designed to match the bond payments due by the Corporation.
The bonds are therefore secured by the revenue stream provided to the Corporation by the lease payments from the District. What shows up on the financial statements of the District aren’t the COPs, but the lease payments, which are budgeted annually, not as a formal, long-term commitment.
Investors, of course, are not fooled by this. The entire term of the lease shows up on District’s Comprehensive Annual Financial Report (CAFR) as a Capital Lease, as a long-term obligation (see Note 10, p. 66), not just the next year’s payment. They show up directly, as “Certificates of Participation” on the District’s Debt Capacity Schedule 9 (P. 114). If the payments are missed, it will damage the credit rating of the District.
To be fair, JeffCo is far from the only jurisdiction to use this mechanism to get around the ban on general obligation debt. Denver City Council used a similar mechanism to launder its own obligations that it incurred when it backed debt for the Union Station redevelopment project, in order to secure federal funding. This appears to be a legal means of side-stepping the constitutional limitation.
The State Constitution recognizes the danger inherent in debt, which is why bond issues need to be approved. If investors don’t treat the Corporation as a separate entity from the District in evaluating creditworthiness, why should the state?
Here is the relevant paragraph from the debt issuance, describing the shell game, and showing that it specifically contemplates the ban on general obligation debt and is designed to avoid it (emphasis in original):
Neither the Lease nor the Certificates constitutes a general obligation indebtedness or a multiple-fiscal year direct or indirect debt or other financial obligation whatsoever of the District within the meaning of any constitutional or statutory debt limitation. Neither the Lease, the Indenture nor the Certificate have directly or indirectly obligated the District to make any payments beyond those appropriated for any Fiscal Year in which the Lease shall be in effect. Except to the extent payable from the proceeds of the sale of the Certificates and income from the investment thereof, from Net Proceeds of certain insurance policies and condemnation awards, from Net Proceeds of the subleasing of or a liquidation of the Trustee’s interest in the Leased Property or from other amounts made available under the Indenture, the Certificates will be payable during the Lease Term solely from Base Rentals to be paid by the District under the Lease. All payment obligations of the District under the Lease, including, without limitation, the obligation of the District to pay Base Rentals, are from year to year only and do not constitute a mandatory payment obligation of the District in any Fiscal Year beyond a Fiscal Year in which the Lease shall be in effect. The Lease is subject to annual renewal at the option of the District and will be terminated upon occurrence of an Event of Nonappropriation or Event of Default. In such event, all payments from the District under the Lease will terminate, and the Certificates and the interest thereon will be payable from certain moneys, if any, held by the Trustee under the Indenture, any amounts paid under the policy of insurance, and any moneys available by action of the Trustee regarding the Leased Property. The Corporation has no obligation to make any payments on the Certificates.