Pitfalls and Issues in Financing Equipment Leases with Virginia Localities

Community banks are in one of the most competitive lending markets in recent memory. When a well-capitalized developer or business brings its financing needs to the market, there are usually several banks competing for the opportunity. The financing needs of localities in Virginia are often overlooked as an opportunity for community banks.

As outlined below, serving the financing needs of localities can be a great opportunity for additional business, with the proper deal structure and due diligence.

Types of Local Government Equipment Needs

Virginia's local governments acquire a myriad of equipment for providing a vast array of municipal services - public schools, law enforcement, fire and rescue services, communications, drinking water, waste water, solid waste and recycling management, just to name a few. Further, there are equipment needs for all of the administrative services supporting government functions. Cars, school buses, fire trucks, ambulances, radio systems, wireless services, waste hauling trucks, industrial grade water pumps, earth movers, trailers, as well as building equipment such as HVAC systems, security systems, and metal detectors are often financed by localities through equipment leases. Financing this equipment can afford a lender an opportunity to assist its local government and if structured correctly, can add a solid credit to the lender's portfolio.

The Owner Does Not Have to be the County, City or Town

The term "local government" does not necessarily mean the local elected board or council. Water and wastewater authorities, economic development authorities, and school boards can lease equipment. In rural communities, volunteer fire and rescue squads often take ownership in the equipment they use, although a financing lease with the county or town is used. These three-party agreements should be reviewed carefully, to ensure that the lender is protected in its collateral. Moreover, even with a security interest, no lender wants to own a fire truck. Reserves, minimum fund balances, security in bank accounts, and other forms of additional collateral should be considered when entering into a lease transaction with a locality, especially when there could be third-party control or ownership of the equipment.

Tax Benefits to Lender

While equipment financing with Virginia localities can be rewarding in terms of improving the lives, safety and protection of our fellow Virginians, lending in this area is also financially rewarding. If structured properly, the lease payments can be treated as tax exempt for purposes of federal and state income taxation for the lender. While commercial banks may not typically deduct the "carrying cost" (expense incurred to purchase or carry an inventory of securities) of most municipal leases, the carrying cost limitation does not apply to bank-qualified bonds, making them more attractive to commercial lenders. If structured properly and with adequate assurances from the borrower, commercial banks are allowed to deduct 80% of the "carrying cost" of bank-qualified lease payments.

Because the Internal Revenue Code requires localities to document that the bond is a designated issuance and that the locality will not exceed borrowing levels in a given year, the lender should ensure that closing papers provide assurances that the locality is entering into a qualified tax-exempt lease. Further, because true debt issuance under the Virginia Constitution and the Public Finance Act may only be undertaken after compliance with notice and public hearing requirements. Virginia Code § 15.2-2600 et seq, the execution of a standard lease agreement, without more, could create unwittingly an illegal indebtedness of the locality, which could be void and unenforceable. Doubts as to the enforceability of security interests could thus arise. Lenders should engage qualified counsel to review the lease terms to ensure enforceability and assure that the locality has complied with applicable notice and public hearing requirements. Ideally, the lender also should insist upon an opinion as to enforceability from counsel to the locality.

Credit Issues and Analysis

In addition to general documentation concerns and approval requirements, there are a few challenges in credit review for municipal leases. Typically, localities do not have substantial funds in reserve. Localities with large surplus fund balances are often accused by taxpayers of overtaxation. Credit committees are often troubled by small balances, but municipalities are not normal businesses. Although localities cannot print money, they do have the ability to raise revenues as needed to meet their obligations. Leases for essential government services are of high quality; understanding the use of the equipment is critical to credit risk analysis. Compounding the difficulty in credit review is that leases are not a long-term commitment. Each lease is subject to annual appropriation. As such, a new board or council trying to tighten a belt may consider non-appropriation. Again, the lender does not want to own the shiny new fire truck. When third-parties such as volunteer fire departments are also involved, politics can exacerbate this type of equipment financing. Prudent lenders will want to ensure that there is community support for both the acquisition of the equipment as well as making the lease payments. To ensure this, lenders need security backstops, other than just the lease itself.

Credit Enhancement

As noted above, lending to localities presents some unique challenges. However, the risks associated with lending to localities can be mitigated, using some of the same techniques used in lending to commercial enterprises. Provided the locality satisfies the notice and public hearing requirements noted above, the locality has the power and authority to enter into contracts and to grants liens and security interests in property owned by the locality. The locality would be subject to the same rules for creating and perfecting security interests in the locality's property as a commercial enterprise would. Virginia Code § 8.9A-101 et seq

To deal with the appropriations issue and to compensate for a typically thin financial statement, a locality can agree to provide for reserves, to meet anticipated debt service. Those reserves can be held on the books of the locality (similar to a liquidity covenant in a commercial transaction) or be held in a bank account, pledged to the lender. By using this technique, the lender can assure that the debt service will be paid for a period of time, while working through the economic or political challenges the locality is having in meeting their obligations.

With a non-profit organization that is affiliated with a locality (such as a volunteer fire department or rescue squad), credit enhancement is even more essential. The non-profit does not have the same access to revenue as the locality and will depend on the largesse of the locality and local businesses and citizens to fund their obligations. The repayment of the obligations of a non-profit also can be secured by perfected security interests in the collateral, as well as a reserve account on the books of the affiliated locality or a bank account, pledged to the lender.

As we depend more and more on government for services, government will have to acquire the means to provide those services. There are many opportunities for lenders to provide financing to localities and with the right documentation and due diligence, the financing can be done safely and profitably.