i.4.3 Steps Public Agencies Must Take to Use Debt Financing

THE AUTHORITY TO ISSUE DEBT – As a general rule, public agencies only have the powers that are expressly granted to them, are fairly implied from the powers expressly granted, or essential to the declared objectives and purposes of the governmental entity.27 This means that for a public agency to issue debt or generate revenues, state law must expressly authorize the public agency to do so.

As described in Chapter 1 – Legally Incurring Debt – State Law Restrictions on Public Agency Debt and Revenues, most public agencies must look to state statute for authorization to borrow or to generate revenues to repay debt. Under the California Constitution, charter cities must look to their city charters for this authorization. Charter cities are also subject to general state laws, and all public agencies are subject to the California Constitution. In general, when a state statute authorizes a public agency to incur debt and that statute prescribes a method by which the public agency may take the action, the agency may not take the action using a different method. This fact is sometimes expressed as “the mode is the measure of the power.” For example, the courts have ruled that if a statute authorizes a public agency to incur debt and then provides that the public agency is to sell that debt through competitive bidding, the public agency is required to follow that approach.

The California Constitution sets limitations on the debt certain types of public agencies can incur in any given year. Article XVI, Section 18 of the California Constitution prohibits cities, counties, and school districts from entering into indebtedness or liability in any year if it exceeds their income and revenue for that year unless the local agency first obtains two-thirds voter approval for the obligation. This is commonly referred to as the debt limit. School districts have the option to seek authority for indebtedness that requires only a 55% voter approval for the construction or rehabilitation of school facilities (including furnishings and equipment).

There are three main exceptions to the debt limit: (1) the Lease Exception, (2) the Special Fund Exception, and (3) the Obligations Imposed by Law Exception. California local agencies subject to the debt limit rely on these three exceptions to issue the majority of their debt, with the Lease Exception being the most commonly used exception. See Chapter 1 – Legally Incurring Debt – State Law Restrictions on Public Agency Debt and Revenues.

LEASE EXCEPTION – The Lease Exception provides that a long term lease obligation entered into by a city, county, or school district as lessee will not be considered an “indebtedness or liability” under the debt limit if the lease meets the following criteria:

The obligation to pay rent for any rental period is contingent upon the public agency lessee having beneficial use and occupancy of the leased premises for that rental period.

If use and occupancy by the public agency is not available, there is abatement of rent during the period the use and occupancy is not available.

If the public agency lessee fails to pay rent when due, there can be no acceleration of future rent due.

The rent in each year does not exceed the fair rental value of the premises.

A city, county, or school district that is constrained by the debt limit from issuing general obligation debt may choose to enter into a lease based financing, such as lease revenue bonds or certificates of participation in order to avoid the time, expense, and political risk of seeking voter approval of the debt; however, lease based financing are paid out of the agency’s general revenues and, thus, directly affect operating budgets.

SPECIAL FUND EXCEPTION – The Special Fund Exception permits long term indebtedness or liabilities to be incurred without an election if the indebtedness or liability is payable from a “special fund” and not the public agency’s general revenues. Special funds are used to finance an activity related to the source of revenues. Case law has affirmed that when debt is paid from revenues related to the enterprise financed with the indebtedness, the indebtedness or liability is not the public agency’s but is instead an indebtedness or liability of the special fund and thus is not subject to the debt limit. There must be a connection between the project financed with the indebtedness and the special fund. For instance, parking revenues deposited in a special fund cannot be used to finance sewer repairs, because there is no relation between the use of proceeds and the special fund.

OBLIGATIONS IMPOSED BY LAW EXCEPTION – The Obligations Imposed by Law Exception is not frequently used, but has been used to support pension obligation bonds, borrowings used to satisfy legal judgments, and Teeter Plan28 financings to advance delinquent property taxes. An indebtedness to finance an obligation imposed on the public agency by law (e.g., a court order to make a payment that is required by state law) is not subject to the debt limit. This debt limit exception is based on the notion that the obligation is not discretionary, and thus it does not make sense to request voter approval.