Making a revenue bond ordinance work effectively: tips, tricks, and traps.

• Author: Rust, Kenneth L.

A bond ordinance that carefully defines gross revenues and operating expenses, prioritizes payments of expenses, and builds in a rate stabilization fund can lead to greater control of debt service coverage and financial operating results.

One of the most confusing and intimidating experiences that revenue bond issuers must confront is the legal document known as the bond ordinance. The hours spent in document review sessions making sense of this document never fail to leave a lasting impression, whether one is a first-time or frequent issuer. In many cases, the bond ordinance that issuers must work with is based on one developed in some earlier era with origins seemingly as mystical as the biblical 10 commandments.

Oftentimes as the bond ordinance is developed, the needs and expectations of rating agencies, underwriters, and investors are given priority over the interests of the issuer. Rating agencies prefer bond ordinances with "standard provisions" that are clearly understood and are therefore easy to rate. Underwriters prefer to underwrite bonds secured by a bond ordinance that offers a high degree of security for the investor and contains no unusual provisions needing special explanation. Investors prefer to buy bonds secured by a bond ordinance that provides a high level of security, restricts the issuer's ability to "dilute" their claim on revenues through the issuance of additional bonds, and, if they read it, is easy to understand. A bond ordinance that meets these objectives, however, may not be one that the issuer would want to approve because it could seriously impair the ability to manage the enterprise's financial operations over the long term. Issuers need to balance the expectations of the financial markets with their own management and operation requirements.

Many issuers do not fully appreciate that most elements of a bond ordinance definitions, additional-bonds test, amendment provisions - are negotiable and changeable. Furthermore, by understanding how these various promises and commitments will affect the short- and long-term management of the municipal enterprise, issuers can make the bond ordinance work for them, not just rating agencies, underwriters, and investors. This article provides a few examples of how various elements of a revenue bond ordinance can be improved to better serve the issuer.

The Definitions Section

Virtually all bond ordinances contain a section that defines words and terms used throughout the ordinance itself. For revenue bonds, critical terms include gross revenues, operating expenses, net revenues, and debt service. These items combine to form the pledge of revenues available to bondholders and the basis for rate and other covenants promised to be undertaken by the issuer. While many of these terms may appear to bear a strong relationship to accounting concepts of revenues and expenses, this is not often the case. In fact, most revenue bond ordinances deviate from generally accepted accounting principles in the definitions of revenues and expenses and for good reason: rating agencies and investors are interested in cash flow from operations whether or not it is strictly recorded as a revenue or expense item under current accounting standards.

For this reason, it is extremely important that key revenue and expense definitions explicitly include or exclude all items used in their determination. This ensures that the definitions will be used correctly. Problems can occur when accountants prepare reports showing the results of an enterprise's financial operations without understanding the special meanings that have been developed for key financial terms. A good example of this is in the area of system development or connection charges. For many municipal utilities, particularly those in fast-growing areas of the country, charges collected from new connections to a utility can be a substantial and important source of gross revenues available and pledged to bondholders. Under current accounting rules, however, these connection revenues are treated as contributed capital, not as revenue, and are reflected in a utility's balance sheet, not the income statement. Because of this accounting difference, specifically defining gross revenues to include such charges will ensure that financial operating results, debt service coverage (the ratio of net revenues to annual debt service), and other indicators will be correctly reported.

There are limits to what issuers can choose to include or exclude in the defined terms; exceeding these boundaries may result in negative credit rating impacts. Rating agencies frown on the inclusion of items in the definition of gross revenues that are not normal or recurring or that can be manipulated by the issuer in a way that weakens financial operations by reducing annual cash flow generated by the enterprise. Consequently, items such as grants, bond proceeds, insurance proceeds, proceeds from the sale of property, and fund balances are typically excluded from the gross revenues definition. Conversely, issuers have an interest in reducing revenue requirements (cash flow), and the resulting rate increases to the largest extent possible. These competing interests can be accommodated to some degree through the careful defining of gross revenues and operating expenses. A good example of this is in the creation of a rate stabilization fund. The purpose of the rate stabilization fund is to allow for the management of financial performance and debt service coverage over time through the transferring of monies into the fund for use in future years. Transfers to the fund are treated as an operating expense (defined in the bond ordinance) in the year the transfer occurs, and when monies are transferred out of this fund at some future date the transfers are treated as a gross revenue (again, defined in the bond ordinance). This technique enables an issuer to move fund balances to a future date to manage debt service coverage, financial operating results, and rate and revenue requirements without engaging in the practice of "rolling coverage," which is frowned upon by the rating agencies.

Exhibit 1 USE OF RATE STABILIZATION FUNDS (dollar amounts in thousands) Without Rate Stabilization Fund Year 1 Year 2 Year 3 Gross revenues: Fees...