A California School District’s Path To Solar
Law360June 24, 2010
By Lauren Spiegel
Back on Feb. 17, 2009, when magazines and gossip shows were still gushing about the Obamas’ inaugural waltz, President Barack Obama signed into law the American Recovery and Reinvestment Act of 2009. The “Recovery Act” was a $787 billion measure intended to create and preserve jobs and to fund transportation, environmental protection and other infrastructure projects.
One provision in the Recovery Act intended to bring on the stimulus was Section 1521, which created qualified school construction bonds (“QSCBs”). QSCBs (pronounced “Q-scabs” by those in the know) were fashioned as a type of “qualified tax credit bond” intended to provide cheap financing for the construction and rehabilitation of public school facilities.
Under Section 54A of the Internal Revenue Code, the holder of qualified tax credit bonds is entitled to a tax credit equal to a percentage of the principal amount of the bonds held by such holder. The secretary of the Treasury determines this “applicable credit rate” percentage at the time the bond is initially sold at a rate that will allow the bond to be sold without discount or interest cost to the issuer.
In other words, the applicable credit rate should be high enough to get buyers without the issuer having to sweeten the deal but not too high so that the Treasury is giving up any more tax revenue than is necessary to sell the bonds.
In theory, if the issuer can actually sell the bond in the market for the rate that the Treasury has come up with, the issuer gets an interest-free loan. For the issuer, this is an even better deal than a traditional tax-exempt municipal bond where the interest is tax deductible to the holder but the issuer still has to pay interest to the holder (even if the interest amount is less than it would have been had the interest been taxable).
What made qualified tax credit bonds even more enticing back in 2009 was the prospect of stripping. Section 54A of the Internal Revenue Code declared that the Secretary of the Treasury would provide regulations setting out how the tax credits could be “stripped” from the bonds that brought them into the world.
This means that as the holder of a qualified tax credit bond, you could sell the tax credit strip and retain the bond or vice versa. This versatility makes qualified tax credit bonds even more valuable since you can find buyers best suited for the principal strip (such as pension funds that do not pay taxes so could not care less about a tax credit) and buyers best suited for the tax credit strip (such as anyone with a lot of foreseeable tax liability).
While the municipal world waited with bated breath for some stripping regulations, the allocation process for QSCBs began. The Recovery Act authorized $11 billion of QSCBs to be issued in 2009 and $11 billion of QSCBs to be issued in 2010 in order to finance the construction, rehabilitation, or repair of public school facilities.
In addition, the money could be used to finance the acquisition of land so long as the bond proceeds also financed the construction of a public school facility on such land. The Recovery Act requires that projects financed with QSCBs comply with the Davis-Bacon Act meaning that prevailing wages must be paid to the contractors building out the project.
For 2009, California was allocated $1,355,491,000 of the $11 billion authorization. Eleven of California’s largest school districts were directly allocated $581,966,00 of the $1,355,491,000. From the remaining $773,525,000, the California Department of Education (CDE) allocated $73,525,000 to assist charter schools. The remaining $700 billion was allocated by the CDE to local education agencies through a lottery held on Aug. 28, 2009.
One lucky lottery winner was the San Dieguito Union High School District. This district covers about 85 square miles in the northern portion of San Diego County, Calif., and operates four high schools, four middle schools, one continuation high school and one adult education program.
By the time the San Dieguito Union High School District received its $25 million allocation, its neighbor, the San Diego Unified School District, had already sold the first issuance of QSCBs in the country complete with tax credits anxiously awaiting stripping regulations to be set free.
The San Diego deal was ahead of the San Dieguito deal since the San Diego Unified School District was one of the 11 largest school districts in California that received a direct allocation and so did not have to wait for the lottery. The buyer of the bonds issued by the San Diego Unified School District was a Chicago investment management firm, Guggenheim Partners LLC.
The applicable tax credit rate for this deal was 7.87 percent meaning that Guggenheim receives an annual tax credit of $3,053,560 for each year that the $38.8 million of bonds are outstanding.
Between April and July of 2009, four other large school districts that received direct allocations followed San Diego’s lead and issued QSCBs that were also bought by Guggenheim.
By the time the San Dieguito Union High School District received its QSCB allocation through the lottery that took place on Aug. 28, 2009, it was already in the process of researching different approaches to installing solar power generation facilities at some or all of its schools. After meeting with a number of providers and discussing varying deal structures, it decided to negotiate an engineering, procurement and construction agreement with a large solar contractor.
Under this agreement, the contractor would engineer and serve as the general contractor of solar power generation systems at two of the district’s high schools. The district would retain ownership over the panels and facilities and the right to sell the renewable energy certificates (also known as “REC’s” or “green tags”) created through the generation of renewable energy. The district opted for this structure instead of a power purchase agreement where there would be little upfront costs since under such an arrangement the solar provider would own the generation facilities and sell power to the district.
The financing risk in such a structure would lie with the power provider and the price the district would be able to negotiate for its solar power would depend, in part, on the provider’s financing costs. With a QSCB allocation in hand the district was well-positioned to handle the financing of the project itself, pay for the facilities as they are constructed and have no further obligation to pay for the solar power.
In the fall of 2009, the district was underway negotiating its deal with solar contractor and preparing to issue QSCBs in order to finance the solar power installation deal. Then, in early November a legal hurdle arose.
The Recovery Act had provided that the recipient “state” should allocate to issuers within the state. However, it was not clear whether the CDE could properly be considered the “state” for these purposes considering that the California legislature had passed no legislation setting out how the allocations should take place. The San Dieguito deal along with all other QSCB issuances by lottery recipients were put on hold since bond counsel firms were not comfortable in issuing legal opinions that any bonds allocated by the CDE were validly issued and authorized QSCBs.
California Gov. Arnold Schwarzenegger attempted to clear this logjam by issuing a letter granting and clarifying the CDE’s authority to allocate the QSCBs to issuers in the state. Unfortunately, this was not viewed as adequate to handle the concern and there was a scramble to attempt to get the California legislature to pass legislation expressly authorizing, approving and ratifying the CDE’s 2009 QSCB allocation before the allocations expired on Dec. 31, 2009.
No such legislation was passed in 2009, but the CDE agreed to extend allocations of QSCBs on a case-by-case basis. In mid-December, the CDE granted the San Dieguito Union High School District an extension until March 31, 2010, to issue its QSCBs.
The San Dieguito Union High School District rang in 2010 without legislation confirming their 2009 QSCB allocation at the state or federal level. Then, further bad news arrived in January of 2010. Even before the promised stripping guidance was issued, Sen. Charles Grassley, the ranking minority member of the Senate Finance Committee, introduced a bill that would completely prevent stripping of tax credits from their matching principal component.
According to an article in the Bond Buyer on Jan. 7, 2010, one of Grassley’s aides said that the motivation behind the bill is the concern that the IRS will be unable to properly trace ownership of the stripped tax credits in order to prevent abuse. So QSCBs were looking less and less viable as a financing mechanism — assuming the legal hurdles could be overcome, there was still the fact that the market for QSCBs was basically nonexistent and perhaps shrinking.
Meanwhile, another creature of the Recovery Act was thriving — Build America Bonds (or BABs). The Recovery Act added Section 54AA and Section 6431 to the Internal Revenue Code which allows an issuer of municipal bonds to issue taxable bonds and elect either (a) that the buyer of such bonds receive a tax credit equal to 35 percent of the interest on the bonds each year or (b) that the issuer receive a subsidy from the federal government equal to 35 percent of the interest on the bonds.
In the direct subsidy to the issuer structure, investor who do not benefit from tax credits or tax deductions (such as pension plans or foreign investors) are able to invest in the municipal arena while receiving an attractive yield and without leaving any tax benefits on the table. Direct subsidy BABs proved extremely popular. According to the Municipal Securities Rulemaking Board, in 2009, there were 749 BABs issuances totaling $63.9 billion. Every one of these deals used the direct payment option.
The market had spoken and the federal government listened.
On March 18, 2010, to not much fanfare, Obama signed into law the Hiring Incentives to Restore Employment Act. If you heard about this new law at all, you probably heard that certain tax incentives were put into place to stimulate hiring of unemployed persons by private businesses.
But also contained in HIRE was a provision that enables the issuer of QSCBs to forget about tax credits and the complications of stripping and instead receive a BABs-like subsidy.
Under Section 301 of HIRE, the issuer of QSCBs can make an irrevocable election to receive a direct subsidy to cover all or a portion of their interest cost instead of issuing bonds that carry with them a tax credit. The issuer of QSCBs could now issue bonds that look a lot like BABs to the market with no messy tax credit strips.
Plus, the QSCBs subsidy is actually better than the BABs subsidy. While the BABs subsidy is capped at 35 percent of the interest on the bonds, the QSCBs subsidy equals the “applicable credit rate” discussed above. In other words, the subsidy equals the tax credit percentage that the Treasury determines is necessary to make the bonds marketable.
This percentage is published daily at www.treasurydirect.gov/GA-SL/SLGS/selectQTCDate.htm. Note that if the rate published by the Treasury actually exceeds the rate at which the issuer can sell the bonds, the issuer does not get extra cash to do with what it pleases. The subsidy is capped at the actual interest rate on the bonds.
Through HIRE, the federal government also assisted in solving California’s allocation authority problem. HIRE modified the language in the Recovery Act that required that the “state” do the divvying up of that state’s allocation and instead provided that the “State education agency (or such other agency as is authorized under state law to make such allocation)” could do the divvying.
Then, to send bond counsel firms throughout California into an unadulterated state of bliss, on March 25, 2010, Schwarzenegger signed into law Senate Bill 205, which delegates to the CDE the authority to allocate $700 million of the state’s 2009 QSCB allocation and provides that issuers that had received an allocation through the lottery process in 2009 have 120 days from the date of the enactment of this law (in other words, until June 23, 2010) to issue the QSCBs.
On the heels of HIRE, Treasury issued a notice with its promised guidance on stripping (at least in interim form) on March 23, 2010, but by that time it had lost its audience. The San Dieguito Union High School District, at least, was full speed ahead on the direct subsidy bandwagon.
With the solar engineering, procurement and construction agreement with the solar contractor signed and just waiting for the district’s financing to fall into place in order to be effective, the district and its financing team, which included De La Rosa & Co. as underwriter, priced the QSCBs on April 29, 2010. The interest rate on the $13,015,000 of bonds was set at 6.459 percent for their 17-year term. The applicable credit rate on April 29 was 5.66 percent, meaning that the effective interest rate the district has to pay, after taking into account the subsidy, is only 0.80 percent. The bond deal closed on May 10, 2010.
The San Dieguito Union High School District is projected to realize over $10.5 million of gross savings over the next 25 years from its investment in solar financed by QSCBs authorized by the Recovery Act as enhanced by HIRE.
Lauren Spiegel is an associate in the Land, Environment & Natural Resources Division of Manatt Phelps & Phillips, LLP, based in the firm’s Orange County office. The firm served as bond counsel with respect to the issuance on May 10, 2010, of the San Dieguito Public Facilities Authority Lease Revenue Bonds, Series 2010A (Qualified School Construction Bonds — Direct Subsidy).
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