Printer Friendly

Maintaining credit quality.

Finance professionals responsible for debt issuance and management are accustomed to dealing with regular change. These include changes in market conditions that affect borrowing costs, changes in federal tax law provisions that affect borrowing plans and the tax status of state and local bonds, and changes in financing practices and methods developed by the investment banking and financial services industry. Effectively managing these change elements becomes more complicated when the underlying legal framework is subject to actual and threatened change by citizen initiatives. Citizen initiatives, or "direct democracy," are an allowed legal practice in more than half of the states in the country. Although this form of law-making is used to address a wide range of state statutory and constitutional issues, it also has been used to limit and control government resources and expenditures. Well-known examples include Proposition 13 in California, Amendment One in Colorado, and Proposition 2-1/2 in Massachusetts.

The impacts of tax limitation measures on the provision of government services are well documented. However, citizen initiatives also have a profound impact on a government's ability to issue and manage debt. These measures not only threaten credit ratings on outstanding debt, but also pose an even greater risk to a local government's ability to access the capital markets in a timely manner and to execute borrowings under the best possible terms. An active initiative environment complicates a debt manager's ability to develop and execute long-term, cost-effective borrowing programs that, if successful, help lower tax and rate impacts on citizens.
Exhibit 1



Year of Number of Number of
General Initiatives Placed Initiatives
Election on Ballot Approved
 by Voters

1988 5 3
1990 8 3
1992 7 0
1994 16 8
1996 23 6
1998 13 8

The Oregon Initiative Environment

Oregon has a long history with the initiative process. Oregon voters approved the state's system of direct legislation in 1902. Under Oregon law, direct voter enactment of laws can occur in one of three ways:

1) referral of statutory changes approved by the legislation via referendum petition,

2) citizen initiatives promulgating statutory or constitutional changes, or

3) legislative referral of statutory or constitutional changes.

Since 1902, the voters of Oregon have passed 99 of the 288 initiative measures that have appeared on the ballot and 25 of the 61 referenda. During this same time period, the Oregon legislature has referred 363 measures to the voters of Oregon, of which 206 have been approved.

During the past 12 years, initiative activity has grown to become an important aspect of the general election environment in Oregon. As Exhibit I shows, the number of citizen initiatives reached a peak of 23 in the 1996 election. Over the past six general elections, an average of 12 citizen initiatives appeared on the ballot with an overall success rate of approximately 39 percent.

Although the range of issues addressed by initiatives has been extremely diverse, regular and repeated efforts have been directed at local governments. The most popular are restrictions on the amount of taxes or revenues that can be collected. Ten different measures affecting government tax and revenue have appeared on the Oregon ballot since 1978.

A brief summary of these key public finance initiatives, in chronological order, is as follows:

1) Measure 5 Property Tax Limitation (approved by voters)

* Limited local government tax rates to $10/$1,000 of real market value of property

* Reduced school district tax rates to $5/$1,000 of real market value of property

* Allowed for voter-approved general obligation (GO) bonds outside of the tax rate limits

2) "Son of 5" Tax Limitation (defeated by voters)

* Would have required voter approval of new taxes and increases in existing taxes

* Local government fees and charges treated as taxes under the measure

3) Measure 20 - the "Equal Tax" (defeated by voters)

* Would have replaced all state and local taxes and most fees with a 2 percent sales tax

* Would have eliminated ability to issue future GO bonds

4) Measure 47 - Cut and Cap Property Tax Reduction (approved by voters)

* Reduced property assessed values, created new definition of "assessed value"

* Limited growth in future property taxes

* Created fixed-rate levies for local governments

* Allowed for voter-approved GO bonds outside fixed tax rate limits but subject to double majority approval if not approved in a general election

5) Measure 50 - Repeal and Replacement of Measure 47 (approved by voters)

* Enabled certain levies to remain "floating-rate levies"

* Provided constitutional authority to impose "special levies" for tax increment districts

Credit Protection Strategies

Because of Oregon's active initiative environment, the City of Portland has engaged in a number of practices to mitigate, defer, or avoid the potential negative financial and credit impacts of citizen initiatives. These strategies have been developed over the years with the help of bond counsel and other public-finance professionals. This has enabled the city to maintain its "Aaa" bond rating while at the same time creating a number of new credits with ratings ranging from "A" to "Aa1." The city has never suffered a credit rating downgrade as a consequence of an initiative measure passing in Oregon. More importantly, the strategies have become part of the city's overall financial management policies and are institutionalized in the budgeting and financial decision making undertaken by the city council.

Revenue Diversity

One factor that has helped the City of Portland overcome the negative impacts of property tax limitation initiatives is the city's diverse revenue base. As a consequence of the two tax limitation measures approved by Oregon voters (Measures 5 and 50), the growth in city property tax revenues over the past 10 years has been slower than what it otherwise would have been. During the period FY1989-90 to FY1998-99, the city's real market value grew at a compound annual rate of 12.4 percent. Over that same time period, city general fund property tax revenues only grew at an annual rate of about 5.1 percent. However, because the city also collects a business license and utility license tax, the effects of tax limitation were largely offset. During this 10-year time period, combined utility license and business license tax revenues grew at a compound annual rate of almost 8.5 percent. The availability of these additional tax sources coupled with strong growth in the regional economy enabled the city's general fund to grow at an annual rate of 6.3 percent during this time period, about twice the rate of inflation, while at the same time delivering much slower growth in property taxes to citizens.

In addition to mitigating the adverse effects of a specific tax limitation measure, revenue diversification may improve equity by creating a closer link between those who pay and those who receive and benefit from city services. A disadvantage is that many non-property tax revenue sources tend to be cyclical in nature, and are more difficult to forecast accurately. Nevertheless, achieving a diverse revenue mix for the general fund can serve as an important rating factor and be made part of a deliberate plan to insulate and protect the general fund credit rating from adverse initiative impacts.

Protecting the General Fund

Because the city has a large borrowing program and secures a number of bond issues with a pledge of its general fund, protecting its financial condition and integrity is an obvious and important need. A strong general fund credit serves as a key indicator of financial management strength that can support and strengthen the ratings of all outstanding debt. By protecting the financial condition of the general fund, service-level impacts can be minimized, borrowing capacity can be preserved, ratings can be maintained and the "halo effect" of strong management can benefit other parts of a local government's financial operations.

In 1990 when Measure 5 first passed, the city's property tax collections were subject to "compression." Compression occurs when the sum of the city's authorized tax collections and the collections of all other overlapping local governments (non-school) exceeds the $10 rate limit, when expressed as a rate per $1,000 of real market property value. In these circumstances, the property tax levies of all overlapping local governments are reduced proportionally to conform to the $10/$1,000 rate limit. At that time, the city collected property taxes through three separate levies: a tax base levy for the general fund, a special levy to fund police and fire pension and disability costs, and tax increment property taxes collected for the city's five urban renewal districts. In order to minimize compression loss effects on the city's general fund and to ensure the continued ability to fund ongoing police and fire pension and disability costs, the city purposefully decided not to impose any urban renewal levies for a period of three fiscal years. This strategy also was designed to provide time to develop alternative funding plans for general fund activities. During that time period, annual debt service on outstanding tax increment bonds was paid from a combination of excess reserves in the tax increment funds, program income, and, if necessary, from general fund revenues.

Strong growth in the regional economy enabled the city to grow out of property tax compression and regain the ability to impose a tax increment levy beginning in FY1995-96. As a result of this management strategy, the city's general fund only needed to contribute $3.6 million to the payment of tax increment debt service while avoiding general fund and pension system property tax compression losses of about $54 million. While the city's economic development agency was forced to drastically scale back new projects during the early 1990s, it has now regained sufficient capacity to effectively collect tax revenues approximately 60-70 percent higher than the amount collected prior to the passage of Measure 5.

Defensive Bond Issues

Another important strategy to consider in the face of a restrictive citizen initiative is the purposeful incurrence of a debt obligation. The intent of this strategy is to create a binding contract with bondholders that cannot be impaired by the passage of ex post facto laws. This strategy is based on the Contracts Clause of the U.S. Constitution, Art I, [section] 10, par. l, which provides that "No State shall...pass any...Law impairing the Obligation of Contracts..." This constitutional provision has been interpreted and applied in cases to invalidate legislative actions that would have acted to impair contractual undertakings made by municipal entities in favor of bondholders. Two federal cases, United States Trust Company of New York v. New Jersey and Continental Illinois National Bank and Trust Company of Chicago v. State of Washington, are widely cited in support of the contracts clause argument.

The City of Portland has undertaken defensive bond issues on three separate occasions. In 1994, the city issued $250 million of sewer revenue bonds in advance of the November 1994 election that featured "Son of 5," a measure that would have restricted the ability to raise fees and charges without a vote. Because the city is subject to an EPA order mandating the construction of sewage facilities, it was imperative that access to capital be able to continue without interruption. The issue was sized as large as possible in order to carry the city for two plus years of construction, thus providing time to develop contingency plans in the event the measure passed. The city reviewed its financing strategy in detail with the rating agencies, focusing on the contracts clause issues and expected treatment by the courts if the measure passed. Additional efforts to inform and educate potential investors were undertaken, including national investor conference calls and local dealer meetings. Even in the face of election uncertainty, the ratings on the bonds (A1/A+) were not changed and the bonds were sold with very little interest rate penalty, attesting to the strength of the contracts clause argument. Voters defeated the Son of 5 measure in November 1994.

Subsequently, the city issued $80 million of pension obligation bonds and $47.76 million of tax increment bonds in the face of Measure 47 in November 1996. Again, these financings were undertaken in order to create a binding contract that would protect the city's ability to continue collecting taxes beyond the limits specified in the measure.

While the city has not had to test the contracts clause argument in court, it is considered a valuable and effective tool to limit the immediate impacts of an initiative measure. While it is not a long-term solution, it can provide time to develop new tools and strategies to combat the effects of the initiatives and mitigate service level and credit rating impacts.

Broaden Bondholder Promises

A strategy similar to incurring a debt obligation in advance of an initiative is broadening the promises made to bondholders in the Bond Ordinance. The U.S. Constitution, and most state constitutions, contains prohibitions against the impairment of valid and binding contracts. With these constitutional protections in place, issuers can seek to insulate themselves from citizen initiatives that would require a rollback of rates or even voter approval of rate increases by making contractual commitments with bondholders that would be violated or impaired if the provisions of a future citizen initiative were imposed.

In preparation for the passage of "Son of 5" in 1994, the city expanded one of the general covenants it had entered into with bondholders with regard to how its sewer system would be operated. Initially, the covenant read as follows:

"The City shall cause the System to be operated at all times in a safe, sound, efficient and economic manner."

In order to create a more defined standard, and satisfy the contract with the bondholders to raise rates without voter approval, this general covenant was revised to read as follows:

"The City shall cause the System to be operated at all times in a safe, sound, efficient, and economic manner in compliance with all health, safety, and environmental laws, regulatory body rules, regulatory body orders, and court orders applicable to the City's operation of the System, and shall cause to be maintained, preserved, reconstructed, expanded, and kept, with all appurtenances and every part and parcel thereof, in good repair, working order and condition, and shall from time to time cause to be made, without undue deferral, all necessary or proper repairs, replacements and renewals so that at all times the operation of the System shall be properly and advantageously conducted."

This expanded language provides a much greater level of detail about how the utility will be operated and maintained, and is made in the form of a general covenant or promise within the Bond Ordinance. Adopting more descriptive covenants such as this could prove crucial in determining whether or not a citizen initiative limiting the ability to collect, impose, or raise rates has impaired the contract between the issuer and the bondholder. In addition, it provides an easy way to buy protection from future citizen initiatives that might otherwise severely constrain good financial management of the utility or enterprise.

Issuers contemplating this approach will need to receive legal consideration (i.e., the exchange of value between parties to a contract) in the form of bond proceeds in order to create a binding contract. Amending a bond ordinance without the exchange of consideration may not by itself create a binding contract.

Impose Multi-year Rate Increases

A final strategy to mitigate the impacts of a proposed initiative, particularly one that would limit the ability to raise fees and charges without prior voter approval, is having the jurisdiction's legislative body adopt a schedule of rate increases that encompasses multiple years. The intent of this strategy is to create a contractual obligation that would supersede the subsequent initiative, if passed. Jurisdictions often are reluctant to pass multiyear rate increases either because they do not want to bind future city councils or legislative bodies or because they may be legally prohibited from taking actions of this type. This action by itself will not solve the problems associated with a restrictive initiative, but instead is intended to forestall immediate, negative credit rating actions. By creating the time to develop alternatives, implement transition plans, and make necessary changes, it may be possible for the government's finance professionals to "manage" the problem in a way that minimizes both financial and credit rating impacts.

Impacts on Debt Financing

Despite efforts to mitigate the effects of citizen initiatives, the borrowing plans and programs of state and local governments will be affected by the restrictions imposed by these measures. Debt managers will need to develop and execute new borrowing strategies to avoid the immediate negative effects of a proposed initiative.

In Oregon, proposed initiatives are met with a flurry of preemptive bond issues aimed at securing long-term funding based on contracts clause protection. This accelerated issuance pace tends to bring to market a large number of issues within a short time period just prior to the general election date. Because Oregon has a high state income tax, the potential benefits associated with bonds sold to in-state investors is diminished by the supply of new issues that far exceeds in-state retail demand. The result is that more issues are sold at a higher, national interest rate scale, which in turn increases borrowing costs to state and local issuers.

Compounding this problem is the fact that if the initiative does not pass, the preemptive issues may not have been needed at all, or the financing of the underlying project would have occurred over a longer timeframe and possibly under more favorable market conditions. The city's experience with this aspect of the initiative process was most telling following the passage of Measure 47 in November 1996. The pension obligation bonds sold by the city were intended to provide a contracts clause argument designed to protect the continued ability to collect a special levy in amounts sufficient to pay debt service. When Measure 47 was resubmitted to voters in the form of Measure 50, the status of this special levy was put outside the limits of the Measure, thus eliminating the need for the financing. Even though the bonds were sold in commercial paper mode to minimize negative arbitrage and carrying costs, the cost of this defensive financing totaled nearly $500,000. The city council was fully aware of the potential costs and risks of the financing, and treated them as simply the cost of doing business in an uncertain legal environment. Nonetheless, debt managers need to consider these costs as they try and steer their government's credit ratings through uncharted waters.

An uncertain or unstable legal environment also precludes the use of certain financing tools that could contribute to a reduction in borrowing costs. For many years, the city has considered implementing a commercial paper program to provide interim financing for its sewerage facilities construction program. Such a program would help manage the expected large amount of debt to be incurred over a 10-year time period by separating the construction financing decision from the long-term financing decision. If properly managed, such a program could improve both interest earned on borrowed funds and could help in timing take-out or long-term financings in a way that minimizes needed increases in sewer rates. However, Oregon's unstable public finance legal environment has prevented the city from moving forward with this type of program. The concern in this case is that the ultimate security for the commercial paper holder is the city's ability to issue long-term debt. If this ability is threatened, then the city would have no choice but to issue long-term debt in advance of an election featuring an adverse initiative in order to ensure that any outstanding commercial paper program was redeemed with duly authorized long-term borrowing. This start/stop cycle every two years is simply too short a time period for running a cost-effective commercial paper program.

Similar concerns are raised with variable rate debt. The city has received conflicting opinions from its bond counsel regarding whether or not a remarketing of variable rate bonds represents a new issue. The concern is that new issues would lose their contracts clause protection if "issued" (remarketed) after an initiative's effective date. While bond counsel "strongly believe" that such remarketings are not new issues, unqualified legal opinions have not been forthcoming. For debt managers, the inability to obtain such an opinion calls into question whether a variable rate borrowing, regardless of how much money could be saved, is the appropriate funding tool. For these reasons, the city focuses almost entirely on fixed-rate debt for its long-term borrowing needs.

Investor and Market Education

As most debt managers know, investors favor certainty and predictability. The initiative process interjects a large measure of uncertainty that is in direct opposition to the desires of investors. In the worst case, it means that some types of investors will simply choose not to invest in bonds that they feel have legal risks that may compromise their long-term value. To ensure the lowest possible borrowing costs, it is important for issuers to make sure that the universe of eager buyers is as large as possible. To overcome this concern, issuers need to be aware of investor needs and seek to address those needs through clear and concise disclosure, along with a clear plan for managing the initiative risks.

In Oregon, property tax law evolution through the initiative process has spawned new terms such as Real Market Value and Assessed Value to describe the base upon which a government may determine its tax capacity and its annual tax collections. Tax levies have been changed from a dollar-based-levy system to a rate-based-levy system. Voter-approved general obligation bonds, while outside the general property tax limits, now have different approval thresholds depending on whether a bond measure is voted on in a special or general election. Through all these changes market acceptance for Oregon bonds has remained high, due in large part to the efforts undertaken by issuers to educate market participants - rating agencies, insurers, underwriters, and investors - about the underlying legal system and resulting financial and credit strength of issuers.

Rating agencies have taken the position that they will not make rating changes prior to an initiative's passage, and even upon passage will take a wait-and-see approach unless the particulars of the initiative have obvious and immediate negative financial impacts. This rating approach provides the issuer with the time to evaluate and understand the proposed initiative and develop strategies to offset its impacts. Having learned this lesson, the city includes a communication plan with the rating agencies as a key priority in its response to citizen initiatives.

Effective preparation for dealing with citizen initiatives enables debt managers to demonstrate their understanding of the issues and to exercise strong management leadership. The capability and capacity of management is a key factor in the credit rating. A proactive response to credit threats such as initiatives helps bolster the opinion that rating agencies have of management effectiveness and can help to preserve ratings during turbulent financial times.


As much as elected officials and public-sector managers may want to believe that the tax revolt and anti-government sentiment of the past decade already has peaked, the political landscape may well have changed permanently. In many states, well-established anti-tax groups and political action committees sustain themselves through a continual set of citizen initiatives, which for them is not just based on a particular political philosophy but instead has become their business. Consequently, finance professionals and debt managers must learn how to adapt to what may well amount to a constantly changing legal environment. Successful management in this environment requires even greater skill in the areas of financial planning and strategic decision-making. It also requires that managers be prepared to take immediate defensive action if necessary to protect their financial operations, outstanding credit ratings, and access to the capital markets.

KENNETH L. RUST is the Director of the Bureau of Financial Management for the City of Portland. Prior to this, Rust served as the city's Debt Manager. Rust serves on the Government Finance Officers Association's Committee on Governmental Debt and Fiscal Policy and as a member of GFOA's Technology Resource Group.
COPYRIGHT 1999 Government Finance Officers Association
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1999 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:public finance initiatives
Author:Rust, Kenneth L.
Publication:Government Finance Review
Date:Jun 1, 1999
Previous Article:A question of value.
Next Article:Budget retreats for financial planning: the City of Cape Coral experience.

Related Articles
Lending assistance.
Infrastructure financing: searching for solutions.
NHHFA launches initiatives to fill housing supply needs.
Assessing evidence on health sector reforms.
Mark Altieri's Financial Guidance for Every American.
Related Apartment Preservation renovates Rockaway.
Nonprofit hospital funding stable, but clouds on horizon.
New owners to invest $52m improving Brooklyn complex.
Dubai Islamic Bank signs up with Emcredit for credit information services.

Terms of use | Privacy policy | Copyright © 2020 Farlex, Inc. | Feedback | For webmasters