Q: During the past 10 years, what changes have you seen in California's lease market?
A: Well, 10 years ago, certificates of participation were kind of a novel, controversial instrument. And now nobody remembers that there was anything other than COPs. It used to be that everybody did lease revenue bonds. But COPs have overtaken the entire market. I think primarily because they can be done on a negotiable basis, while lease revenue bonds typically require competitive sale.
Q: How are California COPs different from those in other states?
A: I've not done a COP in other states, but I think we are different from the other 49 states. For one thing, everybody else uses these non-appropriation leases. In California that is legal, although a little bit suspect, because of a doctrine called economic compulsion. In California, what we use is the abatement lease.
Also unlike many other jurisdictions, there are a lot of cases in California upholding the lease exception. Other jurisdictions don't have any cases at all. So you'll occasionally see a story in The Bond Buyer about a lease in some jurisdiction being thrown out as being illegal.
Q: Let's talk about that. Does California have a long history of case law supporting leases?
A: Yes. I guess the cases go back at
least 40 or 50 years. There's a case called Dean v. Kuchel. That's one of the earliest cases. It's a Supreme Court case upholding a long-term lease entered into by some entity that's subject to the California debt limit. Since then there have been a number of other cases, a couple of cases invalidating leases for one reason or another, but by and large they've been upheld.
As long as a few things are true, these leases seem to be valid. They have to be entered into in good faith. The rent has to approximate or not exceed the fair rental value of the thing that's being leased. There has to be an abatement provision and a couple other requirements.
Q: What do you think of the state's legal argument that the COPs sold by the Richmond school district are invalid because they funded operating expenses?
A: I don't think there's any basis in the case law for upholding or rejecting the validity of a lease based on the use of the proceeds of the COPs. The state's argument that Richmond used the money for operating purposes, and therefore it's invalid. overlooks the fact that a good chunk of those proceeds were used for capital purposes.
To take that its logical conclusion, does the state really intend to argue that the lease is partially valid and partially invalid? Well, part of the proceeds were used for operational and part for capital. Could they have done two leases for the same amount of money, one which would be valid and one invalid? I just don't think the state has a winner there.
Q: How has the case affected your legal opinions on lease financings? Is it more difficult now?
A: Well, it's a little more complicated. We have not really encountered any market resistance yet. The rating agencies have made some noises about what they will or won't do. We certainly haven't had a deal before them that is an asset transfer for operating purposes, which is the type they are specifically focusing on. To my knowledge, we've never done a financing for operating purposes, other than a short-term capital borrowing.
So far the case has had no effect on us. But what the attorney general is asking for is that asset transfers be declared unconstitutional, and that could have an impact on issuers.
Q: How so?
A: Well there are some very good reasons to do an asset transfer. There are a lot of reasons to do asset transfers other than to pay for operating needs. When you do an asset transfer, you remove the risk of completion from the project. You also remove the amount of capitalized interest that is necessary. So, it's cheaper for the issuer.
Q: Do you think the Richmond situation is an isolated case or are we going to see more Richmonds? Is this default the tip of an iceberg?
A: I don't think so. I don't think there have been very many operating issues done. It really isn't a very good business decision. I don't think it's been done very often. It puts off till tomorrow today's problems. Therefore, I think if it's the tip of an iceberg, it's a very small iceberg.
Q: What do you say to an issuer interested in structuring a COP financing?
A: I haven't really changed my tune. I have said all along that all things being equal, an issuer ought to do a lease revenue bond rather than a COP.
Q: Why?
A: Well, because all the cases are on lease revenue bonds. None of the cases are on COPs. As far as I am aware, there has never been a case regarding the validity of COPs. Now I don't think there's any doubt about their validity. And there have been about a thousand validation suits that have never gone the wrong way. So now people don't even require validation suits anymore. But there is just a slight preference [for lease revenue bonds] in my mind.
Q: In light of the Richmond default, what is the future of lease financings in California?
A: I frankly don't see much impact, unless this court comes out and makes some ruling calling into question the validity of all COPs, which is possible. Unless the court does that, I don't think you're going to see a great impact on the lease market.
Certificate of participation financings are popular in California, but also face increased scrutiny. Local governments like the flexibility of COPs, which are not considered debt and do not need voter approval.
Unlike lease deals in many states, California's stipulate the obligation of the lessee to appropriate payments. They do not have non-appropriation clauses, instead allowing for abatement of payments if the financed property cannot be used or occupied. The deals also avoid the "economic compulsion" doctrine, which treats such issues as debt if an issuer appears committed to long-term payments.
But some market participants questioned the security of certain lease financings last year when the Richmond Unified School District filed for bankruptcy and defaulted on a $9.8 million COP issue. The state now argues in a lawsuit that the issue is invalid because it funded operating expenses.
Richard M. Jones, head of public finance at the law firm of O'Melveny & Myers, has a bird's-eye view of the California lease market. His 10 years-plus of lease experience include work on numerous COP issues for counties such as Los Angeles and San Diego.
In an interview with staff reporter Debora Vrana, Mr. Jones said the lease market should stay vibrant so long as the courts do not invalidate the Richmond COPs.
