WASHINGTON--The Texas Supreme Court is being asked to review an appeals court ruling that found a municipal lease contract to be unconstitutional debt because it contains a clause pledging the municipality to seek appropriations for lease payments each year.
Since such "good faith" or "best efforts" clauses are common in lease-purchase financings in Texas and the rest of the country -- and often are included at the behest of investors, insurers, and ratings agencies -- the case is sending jitters through the leasing market.
The Austin appeals court, in a decision issued on July 24 in Capital City Leasing Inc. vs. City-County Solid Waste Control Board, found that a requirement in the board's equipment lease contract that it seek appropriations each year negated the board's right to terminate the contract and created a debt as defined by the state constitution.
But since the lease did not comply with the constitution's requirement that debt be backed by taxes and a sinking fund, the court declared the lease invalid.
Texas attorneys and bond dealers said the lower court ruling has created a "chilling effect" on lease-purchase financings by local governments around the state, where many issuers and investors alike are just beginning to realize the implications of the decision.
"Good faith" or "best efforts" clauses are added to contracts to assure investors that a municipality intends to honor the contract, despite its right to terminate it under other standard contract provisions, attorneys said. Lease contracts with such clauses are designed to ensure that they are terminated only if a municipality is not able to pay, the attorneys said.
In the Texas case, the county board decided to terminate the four-year contract after only one year, even though it had money available to honor the lease commitment. When the leasing company sued for payment, the board argued before the appeals court that the provision requiring it to try to make payment was unconstitutional.
The appeals court's endorsement of that argument throws into question whether lease contracts can impose any obligation at all on municipalities to pay beyond the current fiscal year, and is thus making it difficult for bond attorneys to render opinions on long-term lease issues, said Peter M. Kreisner, attorney for Capital City Leasing Inc.
In an Oct. 11 brief raising the case before the Supreme Court, the leasing company contends that the lower court erred in ruling that the "good faith efforts" clause creates debt. Mr. Kreisner said he has invited municipalities, bond dealers, and attorneys from all around the state to file amicus curiae briefs explaining to the court the potentially broad and seruous ramifications of the lower court opinion.
The court has not yet indicated whether it will grant a hearing of the case, but several attorneys said it may do so because the case centers on an issue of constitutional law where the case law is more than 70 years old.
While the lower court decision sent many bond attorneys scurrying to determine whether their outstanding or pending lease contracts might contain offensive provisions, not all the state's finance officials say they are concerned about the implications of the decision.
"We don't intend to join in the case. Why should we?" said Danny Burger of the Municipal Advisory Council of Texas. He estimated that between $100 million and $200 million of city and county lease-purchase contracts are affected by the decision, and of that amount, only a small percentage were financed with certificates of participation.
Most equipment purchases by local governments in Texas are financed with debt backed by ad valorem taxes, as required under the constitutions, he said. According to Securities Data Co./Bond Buyer, however, outstanding certificates of participation and other lease issues by local authorities in Texas since 1985 totaled $383.3 million.
The state's lease financings, including about $450 million of outstanding issues, also are not threatened by the appeals court decision, according to Glen Hartman, executive director of the Texas Public Finance Authority and Jim Thomassen, chief of the state attorney general's public finance section.
"Although this case is potentially troubling insofar as city and county lease-purchase financings are concerned, it is my view that it does not affect state lease agreements which are subject to appropriation," Mr. Thomassen concluded in a Sept. 18 memorandum to Mr. Hartman and Tom Pollard, executive director of the Bond Review Board.
The memorandum noted that the Texas Supreme Court in 1985 rules that appropriation-backed lease offerings by the state are not debt and do not violate the constitution, in the case Texas Public Building Authority v. Mattox. That case -- which still takes precedence over the lower court decision -- has been the authority for all subsequent state lease issues, the memo said.