(from Maine Townsman, January 2009)
By Lee Bragg, Esq., Bernstein, Shur, Sawyer & Nelson
1. What are the State statutes that govern borrowing by local governmental entities?
There are five statutes of interest in this regard. All five statutes are located in Title 30-A of the Maine Revised Statutes.
Section 5702 contains a limitation on the amount of debt that municipalities may incur. A municipality cannot issue debt (for purposes other than school purposes, storm or sanitary sewer purposes, energy facility purposes or for municipal airport purposes) that would exceed 7.5% of the municipality’s last full state valuation. The statute contains additional limits for school purposes, storm or sanitary sewer purposes, energy facility purposes and for municipal airport purposes. Finally, there is an overall debt limit for all types of debt of 15% of the municipality’s last full state valuation. Municipal and district charters sometimes contain specific debt limit provisions, and there are also other State statutes that deal with borrowing by districts. Section 5703 states that certain types of debt do not count toward the debt limit outlined in Section 5702. For example, Section 5703 states that tax anticipation notes and revenue anticipation notes do not count toward the debt limit outlined in Section 5702.
Section 5771 deals with revenue anticipation borrowing and provides that a municipality by vote of its municipal officers may, in any municipal year, borrow money temporarily and issue notes in anticipation of taxes, and State and federal revenue-sharing money. The amount borrowed in anticipation of taxes may not exceed the total tax levy of the preceding municipal year (with an exception for transition budgets), and must be repaid within one month after the end of the municipal year in which the loan was made. (with an exception for transitional budgets).
Section 5772 governs the issuance of general obligation securities and states that a municipality may issue general obligation securities for funding or refunding all or part of its debt and for any purpose for which it may raise money. Charters and other statutory provisions speak to the issuance of general obligation securities by special-purpose districts. The legislative body must authorize the issuance of the bonds. Once this is done, the municipal officers have the authority to issue bond anticipation notes prior to the issuance of the permanent financing.
This section also contains the requirement that a financial statement must be prepared by the treasurer to accompany any questions submitted to the electors for ratification of a general obligation bond issue. The required elements of a financial statement are included in the statute. Municipal general obligation securities have a term limitation of 30 years, although this provision is generally not applicable to special purpose districts.
Section 5773 deals with borrowing in anticipation of federal or State aid and authorizes the municipal officers to contract for and accept a grant of federal or State aid for any purpose for which a municipality may raise or expend money. This section also authorizes the municipal officers to borrow money on a temporary basis pending receipt of the grant funds.
2. Are there federal laws that govern borrowing by local governmental entities?
The Internal Revenue Code (the “Code”) contains extensive regulations governing the issuance of tax-exempt debt by governmental entities. The relationship between State law and federal law is essentially as follows:
State law establishes the types and amount of debt that can be issued, along with requirements that control the manner in which debt is issued. Federal law dictates when debt can be issued with an exemption for federal income tax purposes.
Maine law does provide that the interest and dividends paid on general obligation securities issued under §5772, mentioned above, are exempt from taxation by the State of Maine, whether or not such income is subject to taxation under the Code. Only the federal government, however, can bestow tax-exempt status on government bonds for federal tax purposes. It is, therefore, sometimes necessary for governmental entities to issue bonds on a taxable basis even though the State of Maine has authorized the purpose, due to the fact that certain features of the bond issue do not meet the requirements of the Code for tax-exempt borrowing.
A provision of the Jail Consolidation Act passed in the last legislative session provides an example of this circumstance. Counties that are using a 6-month budget to change the start of their fiscal year from January 1 to July 1 are authorized to borrow the amount of the 6-month budget for a term of 5 years. The Code does not provide tax-exempt status for revenue anticipation bonds that have a 5-year term. County bonds issued for this purpose must be issued on a taxable basis, which can increase the interest rate by several percentage points.
In short, bonds can only be issued by local governments with an exemption from federal taxation on the interest if the issuance is for a purpose authorized by the Code and meets all of the requirements of the Code that apply to the particular type of bond. Bonds that are initially deemed to have tax-exempt status can lose this status, or become subject to rebate requirements and penalties, if they do not meet certain post-issuance conditions such as spend-down deadlines and arbitrage and yield limitations.
3. What is the difference between a note and a bond?
These terms are often used interchangeably, although the word “note” is commonly used to refer to a security that has a term of one year or less, and the word “bond” is commonly used to refer to securities that have a term of more than one year.
4. What is the difference between a general obligation bond and a revenue bond?
A general obligation bond is issued on the strength of the full faith and credit of the issuing entity with a pledge of the entity’s power of taxation to guarantee repayment of the bond. A revenue obligation bond pledges the revenue from a particular source such as water or sewer rates to the repayment of the bond. Revenue obligation bonds are usually issued by districts because they do not have ad valorem taxing authority.
5. Why do tax-exempt bonds command a lower interest rate than taxable bonds?
The buyers of tax-exempt bonds are not required to pay income taxes on the interest that is earned on the bonds, and they can, therefore, gain the same level of profit by charging a lower interest rate. One of the primary functions of bond counsel is reviewing all of the details of the bond issue in order to insure that the issue is eligible for tax-exempt status. This status is then guaranteed in an opinion letter, and bond buyers require and rely on this opinion letter when buying tax-exempt bonds.
6. What is an allonge, and when can it be used?
An allonge is simply an amendment to an existing note or bond that is used when the governmental entity and the owner of the note or bond mutually agree to extend the term, adjust the interest rate or modify some other provision of the original issue. An allonge is most commonly used to extend the term of temporary financing when permanent financing has not been obtained as quickly as initially planned.
7. What are Private Activity Bonds?
Private Activity Bonds are securities issued by governmental entities that provide a certain percentage of the benefit to a private entity. Securities of this type were previously known as Industrial Revenue Bonds. The Code contains guidelines for determining when a security must be treated as a Private Activity Bond, at which point an analysis must be made as to whether the bond is still eligible for tax-exempt status. If 5% or more of the benefit, use or capacity of a capital improvement project is dedicated to, or designed to benefit, a private entity, the security becomes a Private Activity Bond. A project of this nature might still be eligible for tax-exempt status if it meets all of the requirements of one of the approved tax-exempt categories of private activity financing. Some time ago, the Code was amended to reduce the number of categories of private activity projects that are eligible for funding on a tax-exempt basis.
8. What is arbitrage, and when is it permissible in the context of a tax-exempt bond issue?
Arbitrage is the practice of earning interest on borrowed money. Earning arbitrage on the proceeds of a tax-exempt bond is lawful and appropriate, provided that it complies with the limitations contained in the Code. The proceeds of notes and bonds that are issued on a lump sum basis (as opposed to a draw-down, or as-needed, basis) should be invested until the money is needed for the project or purpose for which it was borrowed. Different rules apply in different situations so it is advisable to consult with bond counsel regarding the requirements for a particular bond issue. Depending on the amount and type of the bond, interest earned on the bond proceeds might have to be rebated to the Internal Revenue Service, although interest earned on the proceeds of bond issues that have a value under $5,000,000 is generally exempt from rebate requirements for 3 years, after which the yield on any remaining proceeds needs to be restricted to the interest rate being paid on the bond.
9. What is the borrowing limit for tax anticipation notes?
State Statute sets a borrowing limit for tax anticipation notes at the total tax levy of the preceding municipal year.
Federal law sets a separate limit for tax anticipation notes. The federal borrowing limit for municipal tax anticipation notes being issued on a tax-exempt basis was changed a number of years ago. The limit is determined by calculating the maximum “cash flow deficit” plus an amount not to exceed five percent of the town’s expenditures for the prior fiscal year.
10. Is it permissible to use general funds, or undesignated surplus, to finance a project temporarily, pending the receipt of bond proceeds?
Yes, if the governmental entity intends to reimburse general funds with bond proceeds within 60 days of the use of the general funds for this purpose or the governmental entity has adopted a statement to that effect, called a declaration of official intent or a reimbursement resolution. Some expenses, such as engineering and design fees, are exempt from the 60 day requirement. The logic behind this requirement is that, in the absence of the statement of intent, bond funds that are paid into the entity’s undesignated surplus account appear to have been borrowed for a purpose other than a qualified tax-exempt project. A declaration of the issuer’s official intent to reimburse itself must address a number of points. Bond counsel should be consulted whenever undesignated surplus is being used temporarily to finance a project, in order to insure that all of the Code requirements have been met.
11. When is it possible to pre-pay or refinance existing debt?
Outstanding notes and bonds can be refinanced as long as the original documentation does not contain restrictions on pre-payment. Most debt obligations issued to commercial banks can be pre-paid at any time, and can therefore be refinanced. This rule also applies to loans obtained through the United States Department of Agriculture Rural Utilities and Rural Housing Programs and to loans obtained through the Revolving Loan Fund Programs at the Maine Municipal Bond Bank. Bonds issued through the regular Maine Municipal Bond Bank spring and fall bond sales have restrictions on pre-payment, although the Bond Bank refinances the aggregate issue when it is advantageous to do so, and passes the savings on to the participants in the aggregate issue.
Bonds that are marketed directly and sold publicly by governmental entities can be structured in any fashion that is deemed advantageous to the issuer. These bonds often contain a pre-payment restriction for a set period of time, such as 10 years, after which the bonds can be pre-paid or refinanced. Bonds are sometimes structured in a way that allows pre-payment at a premium on the interest rate, and the amount of the premium might decline as the bond approaches maturity.
The retirement of existing debt with new bond proceeds is referred to as a current refunding. It is also possible to restructure debt through an advance refunding, whereby the proceeds of a new bond issue are invested and then used to make the debt service payments on the original bond. Under some market conditions, an advance refunding can reduce the overall interest cost on an original bond that contains pre-payment restrictions.
Lee Bragg is a partner with the law firm of Bernstein, Shur, Sawyer & Nelson. His practice is limited to the representation of municipalities, school units and special purpose districts. He devotes a significant portion of his practice to public finance, and is currently acting as bond counsel for numerous municipal, school and district projects throughout the State. He can be reached by phone at (207) 623-1596 or by email at email@example.com.