Anatomy Of A Bond Issue
For many local government officials and solicitors, a bond issue is a rare occurrence which is shrouded in mystery. Like most things in life, it is only mysterious because it is unfamiliar. Once you understand the participants and the steps, the process makes more sense.
A. The Participants
The most important participant in a bond issue is the issuer of the bonds. The issuer is the one with the ultimate need: money for capital projects or for a refunding. All of the other participants are there to assist in raising the money.
The investment banker, also known as the underwriter, markets the bonds to the public and agrees to buy the bonds from the issuer and resell them to the bond purchasers. Many times, the underwriter also helps the issuer structure the bond issue and prepare the disclosure document. In other instances, a financial advisor will help the issuer structure the bond issue, prepare the disclosure document, and solicit bids from multiple underwriters. It is also possible for a bank to directly purchase an entire bond issue; in such case, the issuer usually issues one note rather than multiple bonds, and there is no public offering.
The issuer's solicitor represents the issuer in the financing and delivers a legal opinion at the closing. The solicitor's opinion usually covers the following matters: that the issuer is validly existing, that the issuer's officers validly hold their offices, that the public meeting at which the bond issue is approved was properly called and held, and that there is no material litigation pending against the issuer.
Usually the issuer also retains a bond counsel firm, which specializes in bond issues, to work with the solicitor on the legal aspects of the financing. Bond counsel cooperates with the issuer and the underwriter in structuring the transaction, with particular emphasis on legal matters related to state law approvals and compliance with the federal tax laws. Bond counsel also delivers an opinion at the closing.
Once the bond issue is closed, debt service payments are made by the issuer to the bondholders through a paying agent or trustee, which is a bank chosen by the issuer. If the bond issue ever goes into default, the paying agent or trustee usually represents the bondholders in remedial proceedings against the issuer.
It often makes economic sense for the issuer to pay a third party to guarantee the bond issue -- this is called credit enhancement. An insurance company may issue an insurance policy guaranteeing payment of debt service on the bonds, or a bank may issue a letter of credit to guarantee the bonds.
B. The Steps
The first step is for the issuer to select bond counsel and the underwriter or financial advisor. The issuer and the solicitor work with these participants to structure the financing. Some basic questions need to be answered: (1) what is the purpose of the issue -- to fund a capital project, to refund prior debt, or a combination of both? (2) what are the legal parameters involved -- does the capital project serve a proper legal purpose, can the debt be refunded under the federal tax rules? (3) how should the bonds be sold -- through negotiation with one underwriter or through a bidding procedure with multiple underwriters? (4) does credit enhancement make economic sense (that is, is the cost of the insurance or letter of credit less than the resulting debt service savings to the issuer)?
Once the structure is formulated, the issuer needs to select the paying agent or trustee and the credit enhancer, and all the participants begin to prepare the required documentation. The underwriter or financial advisor and the issuer prepare the disclosure document which is usually called the preliminary official statement. Bond counsel drafts the ordinance or resolution and other legal documents.
When the preliminary official statement is in proper form, it is distributed to potential purchasers. The marketing period usually lasts about one week. At the end of the marketing period, the issuer holds a public meeting at which time the bond sale is held.
If the issuer has chosen a negotiated offering with one underwriter, then the underwriter comes to the public meeting with a firm purchase proposal. If the issuer has chosen an offering with bids from multiple underwriters, then the financial advisor collects the bids on the day of the public meeting. The issuer then accepts the purchase proposal at the public meeting by adopting the ordinance or resolution prepared by bond counsel.
In recent years, issuers and their financial advisors have sometimes solicited bids from underwriters through the internet.
The purchase proposal contains the specific terms of the bond issue: principal amount of the bonds, interest rates, amortization schedule and prepayment provisions. Once the deal is "cut" at the bond sale, the participants then proceed toward the closing. If the issuer is a municipality or school district, bond counsel will prepare a package to be filed with the Pennsylvania Department of Community and Economic Development. The Department has 20 days to approve the bond issue. Usually the closing takes place about one month after the bond sale. Prior to the closing, the bond counsel will distribute for review drafts of various agreements, certificates and legal opinions.
At the closing, the participants execute the various closing documents. The underwriter wires the purchase price for the bonds to the paying agent. The paying agent, at the direction of the issuer, pays the costs of issuance and applies the balance to fund a construction fund or to refund the prior debt. After the closing, bond counsel distributes a complete set of the closing documents to each participant.
C. Miscellaneous Points
Now that we have reviewed the participants and the steps, here are a few miscellaneous points to consider:
No one knows for sure whether interest rates will go up or down in the future. If an issuer asks "will rates go up or down?", financial advisors and underwriters will invariably answer, "I think they may possibly go up [or down], but you can't be sure." If the issuer is satisfied generally with the current interest rate environment and needs the money, then it should proceed with the financing.
Although the financial advisor or underwriter usually prepares the draft of the official statement, it is really the issuer's disclosure document. The issuer and its solicitor should carefully review its contents. No material fact about the issuer should be omitted from the official statement.
If the issuer plans to issue bonds at some point during the year, it may not want to issue tax and revenue anticipation notes (TRANs) during that same year. The issuer should consult with bond counsel about the tax issues involved in this decision.
If the bonds are being issued to finance a capital project, the issuer should focus well before the closing on the investment strategy for the bond proceeds.
These materials are intended to furnish general information and should not be relied upon as advice in specific situations.
Saul Ewing LLP
Centre Square West
1500 Market Street, 38th Floor
Philadelphia, PA 19102
(215) 972-7750 fax: (215) 972-1928