Blowing in from the West: California's disclosure guidelines for land-based securities.

Guidelines assist public officials in developing disclosure documents that fulfill their requirements under the law and minimize their exposure to fraud liabilities.

Each year the Government Finance Officers Association bestows its prestigious Award for Excellence to recognize outstanding contributions in the field of government finance. The awards stress practical, documented work that offers leadership to the profession and promotes improved public finance. This article describes the 1997 winning entry in the training and technical guides subcategory of the Capital Financing and Debt Administration category.

The California Debt and Investment Advisory Commission (CDIAC) devotes a significant amount of its staff resources to educational services, producing reports, and presenting seminars on topical issues in public finance for the benefit of local agencies in California. In 1996, CDIAC produced the document Disclosure Guidelines for Land-Based Securities which addresses the application of SEC Rule 15c2-12 to land-based securities (i.e., bonds issued to finance infrastructure in real estate development projects). This document has become an indispensable reference guide for government agency staff and industry professionals active in this colorful sector of California's public debt market.

Land-based financing emerged as a principal form of public borrowing in California following the voter approval of Proposition 13 in 1978 (though the state's key assessment laws date from the early part of the century). The dramatic reductions in local property tax revenues resulting from this measure, coupled with the constraints on new taxes and general obligation bonds it imposed, presented local governments with the challenge of finding new ways to finance capital projects, particularly in developing areas. (These fiscal constraints were compounded by reductions in federal aid to local governments, which began in the late 1970s following years of steady growth.) In 1982, the California Legislature enacted the Mello-Roos Act (named after sponsors Senator Henry Mello and Assemblyman Mike Roos) to provide local agencies with a more flexible revenue source capable of financing regional facilities not suitable for assessment financing. Since 1983, California local agencies have issued nearly $7 billion of Mello-Roos bonds. Most largescale development projects in California finance necessary public infrastructure through some combination of Mello-Roos and assessment bonds along with developer fees and private funds.

Development Paying Its Own Way

If land-based financing were strictly a California phenomenon, it probably would not be of national interest. But in evidence of the old adage that "public finance blows in from the west," many growing states are, like California, coming to rely more on land-based financing to address the infrastructure demands of growth; states such as Nevada, Arizona, Colorado, Texas, Florida, and more recently, Maryland and Virginia. North, south, east, and west, the politics of growth tend to dictate that new development "pay its own way." Communities are reluctant to subsidize growth with their tax dollars.

The statutory framework of land-based financing of course varies from state to state, but typically the process begins with a local agency forming a financing district that is coterminous with a proposed development project. The agency then issues bonds to finance any combination of localized improvements such as streets, sewers, and water connections, and regional facilities such as schools, freeway interchanges, and parks. The bonds are secured by liens on specified parcels of real property within the district and are neither a general obligation of the municipal issuer nor a personal debt of property owners. As development proceeds, the developer sells completed residential and commercial structures to new owners, who assume responsibility for the tax liens until the bonds are paid off. Delinquencies are remedied through foreclosure, and the liens securing the bonds have no value independent of property values. For this reason, the value of land in the financing district, often expressed in terms of the value-to-lien ratio, is the primary indicator of credit quality.

Disclosure Obligation of Developers

In the aftermath of the adoption by the SEC of Amendments to Rule 15c2-12 in November 1994, it became clear that a key implementation question in California was whether real estate developers initiating land-based financings should be considered "obligated persons" under the rule and be required to disclose financial information to the securities market. In light of this uncertainty, CDIAC became concerned that conflicting interpretations of the amendments may expose public officials to securities fraud liabilities. CDIAC produced the document Disclosure Guidelines for Land-Based Securities to assist public officials in developing disclosure documents that fulfill their requirements under law and minimize their exposure to fraud liabilities.

California's public finance community initially balked at the notion of subjecting developers to continuing disclosure obligations. Official statements prepared for land-based securities offerings in California historically had not disclosed information concerning developer finances, for the reason that the tax or assessment lien securing a bond issue is not a personal obligation of the property owner. According to this view, any sort of developer financial disclosure would be meaningless and potentially misleading to the extent it implied that bondholders have recourse to assets other than the land in the financing district. But the wording of the Amendments to Rule 15c2-12 seems to promote a broad interpretation of the disclosure obligations of nongovernmental entities, and does not condition such obligations upon a contractual commitment to pay debt service. Still, as the CDIAC Disclosure Guidelines observe, Rule 15c2-12 falls short of providing definitive criteria for determining the disclosure responsibilities of developers in land-based financings, and "attempts to decode its language for hidden meetings have tended to produce more in the way of frustration than illumination."

The CDIAC Disclosure Guidelines point out that the real issue in the debate over the continuing disclosure obligations of developers in financings is the relevance of developer financial information to investors in land-based securities, since the continuing disclosure obligation established by Rule 15c2-12 is contingent upon materiality determinations reached at the time of an offering. (Rule 15c2-12 itself is a market regulation rule concerned primarily with when disclosure should occur rather than what should be disclosed.) If developer financial information is material to investors in land-based securities, then it should be disclosed, both to the primary market and secondary markets for these securities. The decision to designate a developer an "obligated person" is merely a procedural matter that follows from this more fundamental determination.

The CDIAC Disclosure Guidelines then discuss the reasons why the creditworthiness of land-based securities issued to facilitate development is inextricably tied to the successful development and sale of properties in the financing district. The early stages of development, when property ownership is concentrated in the hands of one or a few developers, is the period of greatest credit risk for investors because delinquencies on the part of a major property owner can deplete a reserve fund and trigger a bond default. A developer may run out of money and fall delinquent on its tax or assessment installments for any number of reasons, but the most likely is that demand for its completed product simply does not materialize as expected. As development activity progresses and property ownership diversifies, however, debt service payments become less vulnerable to delinquencies of major property owners, improving credit quality. It follows that in an undeveloped or partially developed financing district, the informational needs of investors are not confined to the legal security for the bonds but extend to indicators of the feasibility of the development project itself. In particular, a reasonable investor would consider it important to be informed of facts concerning a developer's experience, its plan for financing the development, and the sources of capital committed to that financial plan.

In summary, the search for continuing disclosure standards for land-based securities ultimately leads to the evaluation of developer financial information within the context of the materiality standard in federal securities law. The SEC's so-called "continuing disclosure rule" ironically leads to the reevaluation of primary market disclosure for land-based securities.

Guidelines for Land-based Offerings

Under Rule 15c2-12, the final official statement is the point of reference for determining the types of financial information and operating data to be reported annually and the obligated persons to whom this information will relate. A sometimes-overlooked provision of the amendments revised the definition of "final official statement" for purposes of the rule, adding the requirement that financial information and operating data be provided for those persons, entities, funds, and accounts that are material to an evaluation of the offering. As a result, Rule 15c2-12 now regulates, albeit indirectly, the contents of official statements in primary offerings. The CDIAC Disclosure Guidelines offer advice on primary market disclosure for the following items:

Security for the Bonds. As a general rule, official statements should disclose complete information regarding the purposes of the offering, the plan of financing, the sources of payment, and any other security for the bonds, as well as all other material information. Additionally, official statements should identify and describe the relevant provisions of the state constitution and statutes and local resolutions that authorize and limit the issuance of the securities. Official statements prepared for land-based securities offerings historically have presented appropriate detail in these areas. The guidelines in this section address the source of payment, land values, and the covenant for superior court foreclosure.

The Developer. It is the view of CDIAC that a major developer initiating a land-based securities offering to facilitate development should be designated an obligated person and subjected to disclosure requirements if the developer is in control of information that is material to bondholders. By designating a developer an obligated person and identifying the categories of financial information and operating data that it must disclose on an initial and continuing basis, the governmental issuer ensures that this flow of information will reach investors while minimizing its own liability for the accuracy and completeness of this information. The key Guidelines in this section address disclosure of information concerning the management experience of the developer and the developer's audited financial statements.

The Development Plan. Because investors in land-based securities have an interest in the diversification of property ownership that results from the successful development and sale of property in the financing district, official statements should provide sufficient information for an assessment of the feasibility of the development plan. Investors consider it important to be informed that the key developer or developers have lined up sufficient funds to complete the project. This in turn necessitates the disclosure of key financial information concerning project costs, revenues, and financing. While the facts and circumstances in each case dictate the appropriate level of disclosure, in general the scope of the development plan is an important determinant of disclosure. The guidelines in this section address the description of the project, land use entitlements, and the developer's financing plan.

Continuing Disclosure Guidelines

In a land-based securities issue, continuing disclosure obligations fall on the issuer - the city, county, school district, special district, or other public entity responsible for forming the financing district - and any developer satisfying criteria established by the issuer for the purpose of selecting obligated persons. During the initial stages of development, investors will closely monitor the developer's continuing disclosure to see if the project is generating cash flow according to expectations so that the developer can cover its costs, including its special tax and assessment obligations. Interest in the developer's continuing disclosure will diminish over time as property ownership diversifies, and the informational needs of investors will narrow to factors commonly associated with the credit analysis of taxbacked securities, such as delinquency rates and assessed valuations.

Continuing Disclosure Undertaking of the Issuer. A land-based financing district is administered by the governmental entity responsible for its establishment. In the documents authorizing the sale of the securities, the governmental issuer covenants to keep accurate records and accounts of tax or assessment collections and all transactions relating to the construction or acquisition of the project being financed. Thus, the governmental issuer of the bonds is in control of key items of information relating to the security of the bonds that should be included in the Annual Report it prepares in fulfillment of its continuing disclosure undertaking. The guidelines in this section address the status of the bonds, special tax/assessment collections, delinquency information, foreclosure status, land values, land ownership, land use, issuer financial statements, and material event reporting.

Criteria for Designating Developers "Obligated Persons." There is more involved in crafting the developer's continuing disclosure undertaking than simply designating the developer to be an "obligated person." To ensure the continuous flow of developer financial information to investors, several issues arising from the logistics of real estate development must be addressed at the outset. In a large-scale project, for example, development responsibilities may in fact be diffused among dozens of entities. Additionally, the governmental issuer must account for the fact that not all significant development interests, however defined, may be identifiable at the time of the offering since property can change hands at any time during the course of development. Rule 15c2-12 addresses contingencies such as these by allowing governmental issuers to designate objective criteria in their continuing disclosure undertakings for the purpose of determining whether an entity is an "obligated person." CDIAC's Disclosure Guidelines discuss the development of criteria for reaching obligated-person determinations that reflect material financial indicators and any nonfinancial impediments to development.

Succession of the Continuing Disclosure Obligation. One implementation difficulty posed by land-based financing concerns the transfer of the continuing disclosure obligation from initial developers to successor developers who satisfy the governmental issuer's continuing disclosure criteria. The enforceability of the continuing disclosure obligation is questionable, since the obligation is tied to property ownership, which is freely transferable. As a result, the successor developer is not party to the bond documents into which the governmental issuer's continuing disclosure criteria are incorporated. In researching this issue, CDIAC staff found that the only arguably enforceable way to impose a continuing disclosure obligation on all successor developers who satisfy the issuer's criteria is to record a covenant against the property itself. CDIAC recommends, consequently, that governmental issuers record a continuing disclosure covenant against the property that incorporates the criteria established by the issuer for the purpose of reaching "obligated person" determinations. The covenant should terminate when the developer no longer satisfies the criteria.

Continuing Disclosure Undertaking of the Developer. The developer should be primarily responsible for the continuous flow of information to the secondary market concerning the status of the development project. In particular, the developer should disclose information on actual absorption relative to projected absorption. Information about absorption - the time frame in which property is developed and sold - is critical to investors because lot sales provide the cash flow necessary to sustain the development project and result in the diversification of property ownership, which improves the credit quality of the bonds. Additionally, the developer should disclose information on the sources of capital committed to its financial plan for development. The guidelines in this section address development activity, the financing plan, financial statements, and retail/commercial vacancy rates, as well as developer material event reporting.

All's Well that Ends Well 

The reaction to the CDIAC Disclosure Guidelines from public and private sector professionals has been overwhelmingly positive. The guidelines have become a standard reference document that has helped to create "a level playing field" in the opinion of many market professionals. More than two thousand copies of the guidelines have been distributed by CDIAC thus far. In addition to the GFOA Award for Excellence, CDIAC received an award from the National Federation of Municipal Analysts for its contributions on this topic.

STEPHEN SHEA is the director of policy research for the California Debt and Investment Advisory Commission, a position he has held since 1989. Steve has written several publications for the Commission, including the Disclosure Guidelines for Land-Based Securities. He received a Master of Public Policy degree from the University of Michigan.

Guidelines are available from CDIAC by calling 916/653-3269. Readers may contact Stephen Shea at [e-mail].