KEY DOCUMENTS

The bond documents – which are distributed in preliminary form to prospective investors and in final form to bondholders once they are sold – are a primary source of information for investors as well as a contract that defines the relationship between all of the parties involved in a bond deal. 

The process of preparing the bond documents involves not only drafting papers and securing agreements but also conducting due diligence to ensure that the documents are correct and accurate.  If bond documents contain material misstatements and omissions of fact of which parties to the agreement were or should have been aware, those parties can be held liable by investors in the event of a default. 

This can be a particular concern for underwriters, which often have deep pockets and can become the insurer of last resort in a default.  While the underwriter relies on representations made by the issuer, the firm must have a reasonable basis for accepting those representations and make reasonable efforts to verify the information contained in the documents.

RECOMMENDATION: Review all bond documents prior to the sale to determine whether the information provided is complete and accurate and immediately bring any errors to the attention of the issuer, underwriter and bond counsel 

While issuer, underwriter and (to a lesser degree) bond counsel have a responsibility to ensure that the bond documents are complete and accurate, it is likely, given the scope and complexity of the transaction, that the documents will contain errors and leave out information that might be of interest to investors. The underwriter, which often has the deepest pockets and therefore the most to lose in litigation, gains some measure of protection by relying on representations made by the issuer, and information provided by professionals, which the firm reasonably believes to be accurate.

However, if misstatements and omissions are brought to the attention of the issuer, underwriter and bond counsel before the bonds are issued, each has a legal obligation to assess whether the facts in question are “material” (i.e., significant enough to potentially affect investors’ decisions) and correct any that are.  If the misstatements and omissions are not deemed to be material, the bonds will likely be issued using the existing documents.  If the misstatements and omissions are material, but unlikely to affect investor interest in the bonds, there may be a brief delay while the documents are revised – often by adding to the list of “risk factors” disclosed in the Official Statement – and re-approved. 

But if the misstatements and omissions point to serious problems with the project that might affect investor interest, or of which other key players (e.g., bond insurers or rating agencies) are unaware, the entire deal may have to be reworked or scrapped entirely.  The latter case is unlikely although not impossible, as is clear from litigation surrounding municipal bond defaults.   

The Official Statement is a detailed description of the bonds that includes information on:

• Terms and conditions
• Order/priority of payments
• Repayment schedule
• Security interest in facility/project
• Default provisions
• Risk factors
• Ongoing disclosure requirements

Bond documents often include financial statements of the issuer – or sponsoring agency if the issuer is a pass-through bonding authority – as well as the project, if it is already in operation.

Bond documents generally contain copies of critical agreements.  These can include:

• Agreements between the project and potential clients, which provide some assurance that the project will have sources of revenue;
  
• Agreements between the issuer and sponsoring agency (in the case of a pass-through bonding authority), in which the sponsor generally pledges that project revenues received by the sponsoring agency will be passed immediately to the trustee until all applicable funds are paid in full, and also that the sponsoring agency will use its powers to keep the project operational; and
  
• Agreements between the issuer, sponsoring agency and trustee, in which the issuer and sponsoring agency agree to the flow of payments and trustee powers described in the Official Statement (including transferring deed to the project to the trustee).

All of these agreements must be approved by the issuer and sponsoring agency, if any.  For example, in order to finance construction of a for-profit detention center through a county-controlled bonding authority, the county government would likely have to approve an agreement with the bonding authority to appropriate funds, seek business, oversee facility operation, etc.

In order for bonds to be issued, the documents must be reviewed by bond counsel who issues an opinion on whether the issuer has legal authority to issue the bonds; whether the indenture and other agreements are valid and binding; and whether interest on the bonds is likely to be exempt from federal income taxes.  In issuing the opinion, bond counsel relies on representations made by the issuer.  The opinion is included in the final package of documents.

The documents may also include opinions offered by counsel for the issuer, sponsoring agency or even the primary client of the project on the legality and enforceability of the agreement.

FEASIBILITY STUDY

When funds for debt repayment are to be derived from project revenues, a feasibility study may be conducted to determine whether project revenues will be sufficient to cover operating expenses and debt service.  The feasibility study will generally present information on: the “market” to be served and the need for additional capacity to be provided by the project; the past financial and operational performance of the enterprise (if already in existence) and/or similar enterprises; the projected financial performance of the enterprise under various scenarios; and the factors that will likely determine the success or failure of the project.

In theory, the feasibility study is an objective assessment of a project’s viability, conducted by an independent expert whose remuneration is unrelated to the report’s conclusions or whether the deal is concluded.  However, if commissioned by an underwriter with whom the analyst has an ongoing business relationship, the report’s objectivity may be compromised by the author’s desire to continue that relationship by telling the investment bankers what they want to hear. 

Concerned residents who believe that a feasibility study presents an unrealistic or incomplete picture of a proposed project may wish to prepare a critique of the study, or produce or commission their own feasibility study.  The critique or alternative study could then be circulated to various interested parties, which might include: the issuer, the underwriter and bond counsel (for whom the study could raise due diligence issues as well as concerns about the project’s viability); rating agencies; bond insurers; potential investors; current bondholders whose interests could be affected; state regulators; and the media.  If the information and problems presented in the study are not particularly surprising or unique, the study is unlikely to generate much interest from the financial community.  However, the critique might generate enough public discussion to cause public officials and/or the financial community to reevaluate the deal.