WASHINGTON -- Your underwriter is checking out prices in the secondary market as he prepares a new lease offering. Up pops a lease deal being sold in your name, at a yield 200 basis points above the one expected on your offering.
No, you didn't forget something.
After some investigating, you discover that an investment bank is offering certificates of participation based on a lease contract between an equipment vendor and another agency in the government. It is accompanied by documents drawn up by the investment bank that look indistinguishable from your own.
It is a vendor lease offering. And, in this case, it is one of what appears to be a growing number of such deals that are being sold to the public without the knowledge or participation of the issuer.
The incident described above happened to Los Angeles County, a market-wise and frequent lease issuer. Lease dealers say it could have happended to any state or municipal government.
Vendor lease offerings may appear to be just like an issuer's own lease securities because they carry the issuer's name and may include offering documents based on the issuer's financial statements and materials.
But they couldn't be more different. Typically, they are derived from small-denomination, short-term lease contracts negotiated between a government agency purchasing equipment, such as computers or school buses, and the company selling the equipment. The government finance officials who normally handle public securities offerings may never know a vendor lease deal has been done.
A vendor's lease contract usually has a clause saying it can reassign and sell its interest in the lease payments to other parties, including banks, corporations, lease wholesalers, investment bankers, and, ultimately, the public.
In a typical transaction, an investment bank buys the rights to the lease payments and either places the lease privately with a small group of investors, or, as in the Los Angeles case, issues certificates of participation giving buyers a share of the lease payments.
The issuer, when it finally finds out about these deals, may be stunned. Los Angeles County believes it had to pay more on its own lease securities because of the higher-yielding vendor deal it encountered. Other issuers, like Washington State and Florida, happened upon similar deals only after misguided investors complained to them about missing payments on their lease investments.
Some Say Vendor Deals;
Number in the Hundreds
The number an volume of publicly offered vendor lease deals are hard to come by. Standard and Poor's Corp. says it has rated about 40 vendor lease deals since January 1990. But lease dealers say the total reaches the hundreds because the market is largely unrated. The rating agency said most vendor deals are under $5 million.
In addition to the public offerings, dealers say hundreds more vendor lease contracts are placed privately with banks, corporations, and institutional investors each year.
They report a brisk demand for the paper because of its typically high yields, made possible by the steep interest rates usually charged on small lease-financed purchases. Many of the deals go off without a hitch and prove lucrative for dealers and investors alike, attorneys and dealers said.
The trade-off is that buyers have no assurance the government making the lease payments will stand behind the deal if various middlemen lose track of the lease payments or cause other mix-ups. Issuers and attorneys say such problems have not been uncommon.
Buyers may not realize where they stand because dealers, operating in a legal gray area, often provide official-looking documents or represent the deals as "direct obligations" of the government.
"The world of leasing is very sub rosa," said a bond attorney who has been monitoring the deals and asked not to be named. "Things happen that you would never see in the bond world. It's like a group of gumshoe salesmen."
Participants in the lease deals deny and subterfuge. "We're not trying to hide anything. Everybody knows this has been going on for years. It's a bit disingenuous for anybody to say they're shocked and they didn't know about it," said Andrew Heath, general counsel of First Interregional Advisors Corp., the leasing affiliate of a New Jersey investment firm.
Like a dozen other firms around the country, Mr. Heath said, First Interregional for years has sold to its largely retail clients what he calls small-ticket lease notes or paper. He said he has experienced and observed no unresolved problems with the handling of such investments.
Dealers say they do not contact an issuer's finance office because they believe lease reassignment provisions already authorize them to offer the securities. One dealer said he was afraid of being turned down by finance officers primarily interested in guarding their turf.
Sally Rutherford, a Standard & Poor's Corp. vice president, said the agency has received an increasing number of requests from investment bankers to rate vendor lease deals in recent months. But in some cases, when the agency contacted the issuers, it found they were not willing to endorse the deals.
The trend prompted the agency to issue a warning in a recent CreditWeek Municipal article saying it will not rate a vendor offering unless the issuer's top finance officers are first notified and grant permission. Since all lease deals are graded in part based on the issuer's willingness to pay, she said, deals without any official blessing raise particular perils for buyers.
Many stalwarts of the bond community remain unaware of the activities. Thomas Bach, an attorney with Sullivan, Donovan, Bond, & Bonner who supervised the drafting of the Public Securities Association's "A Guide to Certificates of Participation," said he has never encountered unauthorized lease deals and suggested they were aberrations.
"I don't think that happens a lot. Maybe with small deals, but certainly the dollar amount won't be big," he said.
But more and more issuers have been encountering the deals and are raising questions about both the disclosure and business practices of firms involved in them. Some issuers, fearful for their standing in the market, have taken strong measures to prevent similar deals from recurring.
Los Angeles County, for one, took to the barricades after stumbling across the vendor lease deal when it went to market its own $28 million equipment lease offering in January 1991. It found the $1.7 million vendor deal, derived from a county modular building lease for juvenile dormitories, had been sold a month earlier by the Chicago Corp.
Negotiated at a higher interest rate than the county's publicly traded lease issues, the unrated five-year vendor deal was yielding around 8.5% on the secondary market -- two points above the 6.5% yield the county had expected on its own five-year offering, said Mark Saladino, the county treasurer's attorney.
The vendor deal was accompanied by offering documents bearing the county's name and an out-of-date county audit and financial statement, he said. "There was no way anybody could tell that the county was not involved in that offering," he said.
The difference in price forced the county to hold off sale of the $28 million issue for a day. When it finally went ahead, fears that the United States would launch into the Persian Gulf war had spooked the market, and the county had to pay between 10 and 20 basis points more than it had anticipated the previous day, he said. That came to $120,000 over the life of the offering.
"There was damage to the county, and it could have been a lot worse had it been a larger issue" like some of the county's recent offerings over $100 million, he said.
Neil Hertenstein, the Chicorp Financial Services vice president who sold the modular building deal, said it was legitimate because the lease contract permits the reassignment of the lease payments. The right to issue certificates based on the lease was not explicit, but was not prohibited either, he said.
The entire incident, Mr. Hertenstein said, was simply "a case of very poor communication" between the county, Chicorp, and Carlson and Hug of Chicago, the tax counsel on the deal.
The original holder of the lease, Atco Structures Inc., a California contractor, had sold its interest in the lease payments to a bank, but did not tell the bank that it received a letter from the county asking it not to securitize the lease, Mr. Hertenstein said.
When Chicorp bought the lease from the bank and stated that it would issue certificates of participation, "they never raised an issue," he said. The securitites firm also wrote a letter to the county informing it of the deal, but he and Mr. Saladino said that it was not received until after the offering went to market.
"The real issue was that the county wants to have control over anything that goes into the market with their name on it," Mr. Hertenstein said. "I totally agree with that. But the problem was that desire was not communicated to us through the chain of people who bought the deal."
Chicorp was preparing to market yet another securitized Los Angeles County lease after the $1.7 million offering, but after the county objected to the first deal, it placed the second one privately, he said. The upshot is, he said, "they're upset, and they probably won't do any more business with us."
Mr. Saladino insisted the problem went much deeper than that, however. In a complaint to the Illinois Securities Department, the county charged Chicorp with providing false and misleading offering materials to investors in the modular building lease.
The offering circular included financial statements and an outside accountant's report that were a year old, were excerpted without permission, and that included revenue streams that were not available for payment of the lease, he said.
Mr. Hertenstein said that the financial statements were old, but they were all that was publicly available at the time. He said he did not attempt to get updated information and was unaware of items in the documents that the county claims were irrelevant. Updated financial documents were published by the county shortly after the lease issue was marketed, he said.
County Appeals Case;
To Illinois Authorities
In a complaint to the Attorneys Registration and Disciplinary Commission of the Illinois Supreme Court, the county charged that Carlson and Hug had been negligent in rendering its tax opinion on the deal.
The law firm had never contacted the county, and its tax opinion relied on an internal legal opinion of the county, given more than a year before the offering, concerning the lease's legality under California law, Mr. Saladino said. The internal opinion had not been updated, he said.
Charles Hug, the attorney who gave the opinion, acknowledged leaning on the county's legal opinion, but said he gave only a tax opinion and was not asked to opine on other legal issues in connection with the deal. He declined to comment further on the transaction.
Besides not communicating with the county, Mr. Saladino maintained that Chicorp and Mr. Hug failed to comply with all the provisions of local law governing the assignment of the lease when they issued the certificates. For that reason, the county has "never recognized the validity of the lease," he said.
Even though he made what he called "a good case for negligence," both Illinois enforcement agencies declined to take action on the county's complaints, he said. Mr. Hug and Mr. Hertenstein also said the agencies found no cause for action. A Illinois Securities Department spokeswoman declined to comment.
"Attorneys from the enforcement side indicated they were not likely to seek civil or criminal penalties unless we could demonstrate there were purchasers within the state," Mr. Saladino said, adding that "I thought it was a little odd" that they declined to protect investors outside Illinois.
Mr. Hertenstein said the agencies decided not to take action because it was primarily "an economic dispute."
"The county claimed economic loss because they had to withdraw their issue from the marketplace," he said. "When it was reintroduced, they could not get the prices they had been told by their investment banking firm they could get. No one will ever know whether they would have gotten those prices in the first place."
But Mr. Saladino disagreed. "We can generally get the best rates that are available in the public market because we are recognized and are in the market constantly." Once again, he insisted that the dispute runs much deeper than merely the shifting economic currents of the time.
"We are a big issuer. There is a secondary market in our paper, so this is particularly abusive because people have no way of knowing the difference between authorized and unauthorized offerings," he said.
"What about a small issuer who doesn't enter the public market very often? It might not know this is being done at all. We happened to find out because we happened to be competing against ourselves on pricing day," he said. "There is a potential for fraudulent individuals to commit larger crimes than this."
With no response from the Illinois agencies, the county wrote about the matter last fall to Cynthia M. Weed of Preston Thorgrimson Shidler Gates & Ellis, the chairwoman of the National Association of Bond Lawyers' committee on professional responsibility.
Ms. Weed said the incident was reminiscent of the problems Washington State has encountered in recent years, troubles that led the state to prohibit such activities.
Echoing Mr. Saladino's concerns, Ms. Weed wrote a commentary on the Los Angeles incident for the association's quarterly newsletter in November, without identifying the county or the firms involved. The commentary questioned whether the companies had engaged in unethical conduct and violations of the Securities and Exchange Commission's official statement filing rule.
Mr. Saladino said the vendor lease offering ran directly counter to an SEC advisory letter in June 1990 to First Continental Corp., which specified that underwriters must obtain and review a nearly final official statement from the issuer before selling certificates of participation to the public.
"Because of that ruling, we felt they should have involved us in the disclosure process. They used the county name and county seal. They were negligent in not contacting the county," he said.
Mr. Saladino said the county council has not decided what, if any, further action it will take, but it may soon refer the matter to California securities officials. He added that the securities officials may also refer the issue to the SEC.
Meanwhile, though the county believes the lease contract and other laws were violated in connection with the deal, it has continued to make payments on the modular building lease certificates, to protect the county's credit standing and good reputation in the market, he said.
To guard against similar incidents in the future, it has started inserting language into its vendor lease contracts prohibiting unauthorized sales and is urging other California counties to do the same, he said.
The language requires firms to get the county's written consent before issuing certificates of participation based on any lease agreement, or providing any offering documents for the sale of such securities.
Mr. Saladino noted that Washington State, when confronted with similar problems, in 1989 enacted a law requiring all vendor lease offerings to be conducted through the state's finance office. "Something like that is needed in California," he said.