What Every Lawyer Should Know About...

Paul D. Speer if Chicago, independent municipal finance consultant for more than thirty years. Although a graduate of Northwestern University Law School and Chicago-Kent College of Law and admitted to practice in this state, Mr. Speer has confined his legal activities to the field of municipal bonds. He has been instrumental in financing such issues as the Sunshine Skyway in Florida and the Green Bay, Wisconsin Lake Michigan Pipe Line.

The title of this article encompasses a subject and a manner of treatment, which if carried out literally, would be endless. Therefore, I will try to cover what I conceive to be some of the principal features relative to municipal bonds.

Probably the first thing we should do is define a municipal bond. One hundred years ago, that would have been comparatively simple as a municipal bond was the written obligation of a municipality to repay, with interest, a sum of money which it had borrowed for its municipal purposes. Usually the obligation was general and without limitation as to the source of funds or to the rate of taxation necessary to be levied to raise those funds. In more recent years there have been developments and enlargements in the field of municipal bonds. So also has there been an enlargement in a description of municipal borrowers originally confined to a municipal corporation. It was early enlarged to include townships, counties, school districts and later to other special districts, and authorities and commissions without any specific boundaries.

In the past year, the amount of municipal bonds issued which were payable from project revenues as compared to general taxes was only slightly less than fifty per cent (50%) of the total issuance. This trend toward revenue financing has been more and more noticeable each year and probably will continue. The reasons are manifold, but basically are found in the fact that general tax rates against real estate and, where taxable, against personal property, have reached practical limits in many cases, particularly when viewed in the light of the combined taxes of overlapping municipalities. The revenues of public projects, when devoted to the operation and financing of the project, have thus relieved the taxes on land and prevented the tax burden from becoming heavier.

There are other forms of municipal bonds, such as special obligations which are limited in their source of payment to special funds of the municipality or a special and limited tax rate, or in many instances to special assessments levied against benefited property.

The important thing is for the lawyer to distinguish between the three types which are the general obligation bond, the revenue bond and the special fund bond.

The general obligation bond in the majority of cases requires authorization by the voters of the municipality and involves the actual levy of, or agreement to levy, general taxes against all taxable property within the boundaries of the municipality which in each year will be sufficient to meet maturing interest and principal and any other obligation of the issue. Normally such taxes may be levied without limitation as to rate or amount, but in certain jurisdictions and in certain instances, either the constitution or statutes provide a limitation on the rate which may be levied against any particular valuation. Such provisions do not detract from the generality of the obligation.

Since there is no lien upon any specific property of the municipality, and the only enforceable right is the right of the bondholder to compel the use of available funds to meet the obligation, and if necessary the levy of adequate taxes for that purpose, it is highly important that the holder be assured that all steps have been taken in connection with the incurring of the obligation as will preserve that right. Laws authorizing municipal borrowing are always construed strictly in order to protect the taxpayers. That is the reason why the opinion of bond counsel, experienced in such matters, is a prerequisite of a satisfactory market. It might be said that this opinion, while not comparable to a title policy, nevertheless serves in a similar capacity.

A revenue bond may be defined as an obligation which is payable from the revenues of a specific municipally owned project, and normally the bondholder has no right to look to any other source of payment. Obviously, therefore, in this type of bond, not only must the buyer look to the bond counsel for evidence as to the municipality's compliance with the pertinent laws but also he must be informed on the revenues or earnings of the project either as they have existed over the past years or as they are contemplated to exist in future years. The estimates and certificates of qualified engineers are the usual forms of such information.

The special obligation is payable only from a special source and usually this is a very limited source. It might be a confirmed roll of benefits against certain property. It might be contingent income of the municipality. It might be the proceeds of a specific piece of municipal property or any one of a number of other sources. Here the buyer must inquire not only into the legal and engineering aspects but should probably go a great deal further and look at the physical aspects.

Historically, municipal bonds came into being to provide funds to pay the cost of capital improvements for strictly municipal purposes. These included the necessary public buildings for government, including legislative and administrative halls and jails. Later were added the now generally accepted purposes of streets or highways, school buildings, sewer systems, water systems and many others, of which probably the most recent is the provision of off-street parking. From time to time, the municipal purposes have been too greatly enlarged and financial difficulties have caused later revision to narrower concepts. One of the better known phases of this expanded financing by municipal obligations occurred in the last century when many municipalities and state issued bonds in aid of railroad construction, canal building and private road building. In recent years in certain parts of the country, particularly in the South, municipal bonds have been issued to construct industrial buildings for lease to private manufacturers on the theory that the availability of such buildings would attract industry and provide employment, the same as any other municipal advantage which the city might have to offer. We will return to the various purposes and the evolution of methods of financing them a little later on.

Because municipal bonds historically carried with them the agreement of the

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* Reprinted from the October, 1955, Illinois Bar Journal.

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municipality to levy taxes to secure the funds to pay them, and because such taxes have always been regarded as superior to any other lien on property, and because the bonds enjoyed a generally excellent record for prompt payment of principal and interest, they have always been ranked next to United States Government Bonds in point of safety. There have been no recent developments to change that viewpoint.

We have discussed the source and method of payment of bonds from general taxes, and we have referred to the payment of bonds from revenues. Obviously, however, there must be special and detailed covenants by the municipality in connection with its pledge of revenues and the obligations under these covenants must be spelled out in much greater deail than in the case of a general obligation bond.

The first and basic covenant of the municipality in connection with a revenue bond should be that it will continue to operate and maintain the project as a revenue producing undertaking and not to sell it or suffer it to become encumbered during the period of the pledge. The next covenant, and equally important, should be the covenant to establish, maintain and collect from the project sufficient revenue to support both the project and the debt service, including all collateral obligations in connection with the provision of reserves. On certain occasions, the funds may be provided from other sources, particularly to pay the operation or maintenance, or both, and in such instances, this covenant is modified so that the pledge is effective only to the extent such funds are not provided from other sources. Many other covenants are normally contained in a revenue bond ordinanice or resolution, but these more or less spell out details which will insure compliance with the basic covenants designed to insure the repayment of the money, with interest, when due.

There are certain instances where actual mortgages or deeds in trust cover property, or a part thereof, the revenues of which are pledged. History has shown that such physical mortgages did not provide added security but rather served to encumber the project to the point where it was difficult to meet all the covenants and such mortgages are little used today. A statutory mortgage has been used in many jurisdictions, the basic purpose of which is to give the bondholder a method of securing enforcemrnt of the covenants securing the bonds and the right to secure the appointment of a receiver for the operation of the property in the event of default in any of the covenants. In some instances this latter has proven satisfactory, but by and large the best protection has been through the ability to enforce compliance with the basic covenants of the ordinance by resort to mandamus or similar proceedings.

It is quite obvious that the three general classes of municipal bonds normally have different values and different attributes of marketability. The prime security is the general obligation bond payable from unlimited taxes issued by a municipality with an unquestioned record for: (a) past adherence to its covenants; (b) excellent municipal operation; and,(c) economic stability. Such securities are selected even at a considerable sacrifice of income because of their top rate security "next to United States Government Bonds in point of safety" and because of their generally wide marketability. Next to them would rank the revenue obligation of a comparable municipality which had a record of revenues from the particular project, or other projects, adequate to service the indebtedness with ample margin of safety and whose covenants not only gave ample protection to the bondholder but which covenants are encompassed in the statutory authority. Of these, the power and agreement to fix and collect the necessary rates without regulation are the most important.

The various utility services provided by municipalities are those which historically have been considered as necessities of community living and basically include water, sewer and now, electricity. Many of these services were originally provided by the municipality from the proceeds of general obligation bonds. Most municipalities, after initial provision of such services, continued to operate and provide them, but with the growth of the private utility industry some fifty years ago, many properties were acquired and integrated into the large private utility systems. Beginning about twenty-five years ago, when private utility holding companies were broken up, this trend was reversed and during the 1930's and even up to today many municipalities have reacquired their water and electric systems. Historically and by reason of complications of easement, etc., the sewer systems were nearly always municipally owned. In the past twenty years the financing of such systems has changed from general obligation or special assessment bonds to revenue bonds based upon rates which are usually an extension of the water rate. In Illinois and many other states the law permits the combination of the water and sewer utilities.

The purposes of acquiring and operating utility systems are varied and differ from city to city and area to area. The most sound reason is to be able to provide better service and in many instances added capital when, due to economic and credit conditions including high tax rates, some utility owners might be unable to carry out necessary expansion. This need for additional capital was one of the main reasons why metropolitan transportation systems were taken over in some municipalities and financed largely by revenue bonds.

There are many types of municipal revenue bonds which have crept into the definition either by usage or by actual method of operation, until today the generic term "revenue bond" includes almost anything except a general tax bond, and it includes almost any purpose that can be conceived within the realm of municipal functions.

Mention has been made of the industrial building financing in the South, some of which has been through the issuance of general obligation bonds and some of which has been done by so-called revenue bonds, which are really nothing more than a pledge of the lease proceeds and should fall in the classification of a special obligation. This type of bond lacks one of the basic essentials of security in revenue bonds and that is that the project is a single purpose project and it is not conducive to rate adjustment to service the debt, as in the case of projects having many users.

We have previously mentioned the provision of off-street parking facilities by municipalities. This has been handled largely in three ways. The simplest of course is the acquisition of parking areas by tax foreclosure or by purchase from current revenues. The second is by purchase from the proceeds of general obligation bonds. The third, and by far the most extensive, is the acquisition, construction and development of off-street parking facilities through the issuance of parking revenue bonds. In some instances these bonds are payable solely from the revenues of a particular project or group of projects. In other instances, they are additionally secured by a pledge of all or a part of the revenues derived from on-street parking meters. This concept has now been accepted by the Supreme Courts of most states.

In either case, however, the municipality offers the parking facilities to whomsoever may desire to use them and with the pledge to the bondholder that it will maintain sufficient rates for use of the facilities to pay all costs of operation and maintenance and to service the debt with adequate reserves. In certain instances one or more of the off-street facilities are leased to private operators at annual rentals calculated to be

sufficient, after the payment of all expenses, to provide the necessary earnings to service the debt. In such cases, however, the municipality retains the right to control the rates so that there will not be a violation of its pledges in connection with the bonds.

Provision of local transportation is not confined to transportation of passengers but also means the provision of other highway services, including the bridging of bodies of water which might bound or divide the particular municipality. In some instances, such services are financed directly by a municipality with a toll charge for the service, but more often these functions have been taken over outside of municipal boundaries and financed by especially created municipal bodies or agencies with no taxing power. This has resulted in the creation of authorities or commissions to provide for the construction and operation of bridges, and to pledge the tolls derived therefrom, and the same applies to ferries and ferry systems. This in turn has provided the pattern for financing the increasing type of public transportation facility known as the toll road or turnpike.

At the present time, such facilities seem to be at the peak of their public acceptance and the only one which has had an opportunity to prove itself over more than a very few years has provided an excellent example of service. More recently opened turnpikes are also proving that they have a high degree of public acceptance. The basic principle of these facilities is that their use is on a purely voluntary basis, inasmuch as no one is forced to use a toll road. Normally, there are free highways between the same points which are adequately maintained but which may not be modern expressways. Toll bridges however might be in a somewhat different category since the bridge provides a crossing where there probably is no alternate free crossing within a reasonable distance. Then the matter of choice begins to narrow.

One of the questions raised in connection with the financing of toll bridges and toll roads is whether or not such facilities should become free to use by the public as soon as the debt incurred to construct them has been retired. The corollary to that, of course, is that they must be maintained and either the city, county or state in whose jurisdiction they lie must accept the expense of such maintenance. Most of the laws governing the issuance of toll road revenue bonds provide for such facilities to become free upon redemption of the debt. This is not the case in connection with toll bridges and there are certain municipalities continuing to charge tolls for the use of the bridges not only to pay the cost of operation and maintenance but also to provide added funds for the municipality.

Most states have strong prohibitions in their constitutions against the incurring of state debt except for very limited reasons, usually for defense from invasion or insurrection, and so the statewide authority with no actual boundaries has been created for various purposes. Not only do we have toll road authorities and toll bridge authorities, but we also have state building authorities, state school authorities and state power authorities or commissions. These state power authorities and commissions are limited by the statutes creating them and are usually not permitted to go into the retail distribution of power. This concept on the wholesale level also has been applied to the storage and distribution of water where groups of cities have banded together to provide a new source of water. Their functions are the provision of power and its distribution, at wholesale to public or private distributors, and for this purpose they often are permitted to transport the power and to own the transportation facilities. Slightly below the state level are distributing and manufacturing electric utilities encompassing one or more counties or groups of cities.

The tax status of municipal bonds has historically been different from other securities. Because the bonds are issued by a municipality which in turn is a subdivision or agency of a sovereign state, the United States Supreme Court has consistently ruled that the Federal Government is without power to tax the interest from such bonds. The Federal Income Tax code has specifically exempted this interest. From time to time efforts have been made to eliminate that specific exemption or to provide specific authority for the taxation of such income by the Federal Government, but so far all efforts both in the courts and Congress have been defeated. The theory of course would be that the power to tax would be the power to control the sovereign functions of a state. Such exemption however does not exist from state to state and between the states. Certain states do exempt or provide tax advantages respecting their own taxes with reference to bonds issued by municipalities within the state. This applies both to general property taxes and to income taxes where they exist. In our own state there is no specific exemption of Illinois municipal bonds from the personal property taxes.

Of course it goes without saying that the tax status of a municipality itself, whether it is operating a utility at a profit or at a loss, is clear and such operation is not subject to the Federal Income Tax. Within the states certain of them provide for setting aside of tax equivalents on municipally operated utilities. That is not the case in Illinois.

One other factor affecting the market value and marketability of municipal bonds is something which applies to other types of securities as well. That is the rating or investment classification by the various recognized investors' services. In the case of corporate securities where reports are required to be filed regularly and made available to the public, such ratings are usually an accurate criterion, In the case of municipal bonds where there is no central point of filing of annual statements and where bonds are issued by a large number of small municipalities, the position of the rating services becomes more difficult. They themselves would be the first to admit that the lack of a rating does not necessarily mean that the security is without merit. More likely it means that the amount of work required to secure the figures for evaluation exceeds the value of the rating to the investment market. It is unfortunate that in the case of municipal bonds certain bank-supervising agencies and others have restricted investment in nonrated municipal bonds on that sole basis. On the other hand the rating of a municipal revenue bond issued on behalf of a large operation and where the figures are readily available, is an excellent criterion of its relative value.

There are many types of investors in municipal bonds. Certain of them, such as public funds and retirement reserves, are required by law to purchase municipal bonds. Many of these laws have been liberalized in recent years, but there are still some with definite restrictions to municipal bonds. Trustees, historically and in part due to statutory restriction, are large investors in municipal bonds The income tax-exempt factor also enters strongly here. For the same reason many very wealthy investors purchase municipal bonds but the number has been far over-rated for political purposes. Institutions such as savings banks and insurance companies are also large investors in municipal bonds due in part to statutory restrictions, but more to the basic quality which attracts all investors to municipal bonds, and that is that historically "municipal bonds rank next to United States Government Bonds in point of safety."