How California School and College Districts Acquire and Manage Debt (Section 4 of 9)

See the complete California Policy Center report For the Kids: California Voters Must Become Wary of Borrowing Billions More from Wealthy Investors for Educational Construction (complete, printable PDF Version, 4 MB, 361 pages)

Links to all sections of this study readable online:
Executive Summary: “For the Kids” – Comprehensive Review of California School Bonds (1 of 9)
More Borrowing for California Educational Construction in 2016 (2 of 9)
Quantifying and Explaining California’s Educational Construction Debt (3 of 9)
You are here: How California School and College Districts Acquire and Manage Debt (4 of 9)
Capital Appreciation Bonds: Disturbing Repayment Terms (5 of 9)
Tricks of the Trade: Questionable Behavior with Bonds (6 of 9)
The System Is Skewed to Pass Bond Measures (7 of 9)
More Trouble with Bond Finance for Educational Construction (8 of 9)
Improving Oversight, Accountability, and Fiscal Responsibility (9 of 9)
Guide to all Tables and Appendices – Comprehensive Reference for Researchers


How Educational Districts Acquire and Manage Debt 

It’s likely that most California voters have limited familiarity with the organization and governance of their local school and community college districts. When voters authorize their local educational districts to borrow money for construction by selling bonds, presumably they trust that the local school or college district will exercise prudence in managing the process.

Sometimes their trust is betrayed.

To discourage abuse of the school construction finance system, voters need to be aware of how their local government is organized and managed. They also need to realize that state law does not explicitly give Independent Citizens’ Bond Oversight Committees broad authority to review construction programs funded by bond measures.

How can voters become informed about bonds and the process of borrowing money for educational construction through bond sales? Is there a way to explain in clear plain language what actually happens after voters approve a bond measure and authorize a school or college district to borrow money via bond sales?

Bonds Help Local Governments Borrow Money to Better Serve the People

When people talk about municipal securities or municipal bonds, they’re talking about state governments or local governments borrowing money from investors with the promise to pay it back to them later, with interest. Municipal (derived from the Latin word municipium, meaning a free city) simply means a local government, such as a county, city, water district, sanitation district, irrigation district, utility district, transportation district, cemetery district, mosquito vector district, and many other kinds of special districts formed by the people to serve the people. And it includes school districts and community college districts.

Despite a lack of public attention to bonds, this method of debt finance is important, especially for governments such as California’s school districts and community college districts that want to initiate or continue major construction programs. U.S. Securities and Exchange Commissioner Luis A. Aguilar recently described the importance of municipal bonds:

It is difficult to overstate the importance of the municipal securities market. There is perhaps no other market that so profoundly influences the quality of our daily lives. Municipal securities provide financing to build and maintain schools, hospitals, and utilities, as well as the roads and other basic infrastructure that enable our economy to flourish. Municipal bonds’ tax-free status also makes them an important investment vehicle for individual investors, particularly retirees. Ensuring the existence of a vibrant and efficient municipal bond market is essential, particularly at a time when state and local government budgets remain stretched.

Such comments are appreciated by state and local governments as murmuring continues in Washington, D.C. that income from municipal bonds should lose tax-exempt status.

Basic Information About California K-12 School Districts

In the case of a local elementary school district (kindergarten though eighth grade), high school district (ninth through twelfth grade), or unified school district (kindergarten through twelfth grades), voters elect a board of trustees (often called a “school board” or a “board of education”) to oversee operations of the school district and make major decisions as representatives of the people. The board appoints a District Superintendent and other professional administrators to handle day-to-day management of the district.

In addition, each county has an elected County Board of Education and an elected County Superintendent of Schools with specific responsibilities. There is also a State Board of Education appointed by state elected officials to oversee education policies that are common for all school districts in the state. There is also a State Superintendent of Schools elected by the people of California.

Table A-1 (“California K-12 School Districts 2013-2014 – Ranked by Enrollment”) lists 945 elementary school districts, high school districts, and unified school districts with enrollment tracked by the California Department of Education as of June 15, 2015.

Basic Information About California Community College Districts

In the case of a local community college district, voters elect a Board of Trustees (often called a “college board” or a “governing board”) to make decisions for the college district as representatives of the people. There is also a Board of Governors of the California Community Colleges appointed by state elected officials to oversee education policies that are common for all college districts in the state. The Board of Governors appoints a Chancellor of the California Community Colleges and other professional administrators to handle day-to-day management of the state college system.

Boards for the University of California and California State University systems are appointed by state elected officials and not directly chosen by the people.

As of June 15, 2015 there are 72 community college districts in California with 112 colleges. (Some districts contain multiple colleges.) Table A-2 (“California Community College District Enrollment Fall 2014 – Ranked by Number of Students”) lists these districts.

What Are the Independent Citizens’ Bond Oversight Committees? 

To strengthen the arguments for Proposition 39 in 2000, the California legislature passed Assembly Bill 1908, the “Strict Accountability in Local School Construction Bonds Act of 2000,” with these stated intentions:

  1. Vigorous efforts will be undertaken to ensure that school and college districts spend the proceeds of bond measures, including those passed under criteria of Proposition 39, in strict conformity to law.
  2. Taxpayers will directly participate in the oversight of bond expenditures.
  3. Members of the oversight committees appointed for these purposes will promptly alert the public to any waste or improper spending of money borrowed through bond sales.
  4. Unauthorized expenditures of school construction bond revenues will be vigorously investigated, prosecuted, and restrained by the courts.

A school or college district board must appoint an independent citizens’ bond oversight committee with 60 days after the board enters the election results in its minutes. The committee must include at least seven members to serve for a term of two years and for no more than two consecutive terms. District employees, officials, vendors, contractors, or consultants are prohibited from serving on the committee, and it must include at least one “active” representative of the following groups:

  1. a business organization, located within the district, representing the business community
  2. a senior citizens’ organization
  3. a bona fide taxpayers’ organization
  4. for a school district: parents or guardians of children enrolled in the district
  5. for a school district: parents or guardians of children enrolled in the district who are also active in a parent-teacher organization, such as the Parent Teacher Association or school site council
  6. for a community college district: students who are currently enrolled in the district and also active in a community college group, such as student government
  7. for a community college district: organizational support groups of the district, such as advisory councils or foundations

These committees have several responsibilities listed in state law meant to ensure the district spends bond proceeds only on projects listed in the ballot statement and avoids spending bond proceeds on ineligible projects, programs, or “teacher or administrative salaries or other school operating expenses.” State law also assigns these committees to review “efforts by the school district or community college district to maximize bond revenues by implementing cost-saving measures.”

The committee does NOT have a explicit oversight role for how the district pays for these construction projects, and a narrow interpretation of the law could claim that oversight committees do not have legal authority to review bond sales. However, the California League of Bond Oversight Committees (CalBOC) believes these committees have the authority to review and comment on the structure of bond issues under the provisions for reviewing “cost-savings” measures. Districts often defer to legal counsel for interpretations of the responsibilities and limitations of oversight committees.

A Private Organization Has Taken Responsibility for Independent Citizens’ Bond Oversight Committees

Currently a private organization is providing services and advice to oversight committees. The California League of Bond Oversight Committees (CalBOC), founded in 2006, is a non-profit public service organization that filled a need for training, education, and legislative advocacy for the state’s bond oversight committees.

This arrangement has shortcomings. A private organization is dependent on voluntary financial contributions and a committed volunteer leadership, and it lacks power to take action against educational districts that fail to comply with state laws. Membership and involvement is dependent on the motivations and self-initiative of individual bond oversight committee members. CalBOC does not have any professional staff to monitor districts, collect data, and provide it to the public.

In addition, school districts can discourage oversight committee members from participating in the California League of Bond Oversight Committees, and some school district administrators openly disparage it. Some district administrators and legal counsel don’t want oversight committees interpreting their purpose broadly and consuming district staff time and district funds on investigations outside of a narrowly-defined purview.

The author of this report has been and continues to be a member of the Advisory Committee for the California League of Bond Oversight Committees (CalBOC).

Translating School Finance Decisions For Ordinary People to Understand

For many Americans, the phrase “stocks and bonds” evokes the image of an established and wealthy investor. Someone who buys a stock becomes an owner of a corporation, and someone who buys a bond becomes a creditor who is owed money by a corporation or a government. It’s likely that more Americans could explain stocks than could explain bonds.

The lack of public awareness or knowledge about bonds may be attributable to the complex provisions of certain bonds and the fact that bonds typically do not offer the very large potential returns offered by equity in growing firms.

Bonds rarely get news media attention outside of a few financial wire services such as Bloomberg, Reuters (which had a “MuniLand” blogger), and specialty publications such as The Bond Buyer. And in popular culture, depictions of bond brokers have been mainly limited to two books by Tom Wolfe: The Bonfire of the Vanities (subsequently made into a movie) and I am Charlotte Simmons.

What Is a Bond?

Some technical definitions of a bond are listed in Table 10. But rather than focusing on the definition of a bond, Californians need to focus on what a bond does in practice.

For a school or community college district, issuing (“selling”) bonds means the district borrows money for a specific length of time from investors with the obligation to return all of that money to them when that time period ends. The amount borrowed is called the principal.

During that length of time the district pays a fee to the investors, either on a regular basis (for Current Interest Bonds) or accumulated with compounded interest at the end of the time period (for Capital Appreciation Bonds). The amount paid is called interest.

The term of maturity between borrowing the money and paying back the money with interest can be one to three years (short-term bonds) or decades (long-term bonds). Under California law, a school district or community college district cannot issue a current interest bond with a maturity over 40 years. As a result of Assembly Bill 182 enacted in 2013, California local governments are now prohibited from issuing Capital Appreciation Bonds with a maturity over 30 years.

AB 182 allows a school district or community college district to issue Current Interest Bonds bonds with a term of maturity between 30 and 40 years. The district must use that borrowed money for projects with a “useful life” that equals or exceeds the term of maturity.

What Are “General Obligation Bonds” Referenced in Ballot Language for Bond Measures?

Corporations and state and local governments issue bonds to raise money. Bonds sold by local governments are called municipal bonds. An appealing aspect of many municipal bonds for investors is their tax-exempt status.

Municipal bonds such as those sold by California school districts and community college districts for construction are called general obligation bonds, meaning they are backed by the “full faith and credit” of the districts. These districts theoretically have legislative power to collect enough money through property taxes, other borrowing, selling assets, or other sources of revenue to fulfill their obligation to make payments on the bonds when due. Those taxes are collected from property owners in the district. (Revenue bonds are another kind of municipal bond, paid off through tolls, lease payments, user fees, or other service payments.)

Comparing Current Interest Bonds to Capital Appreciation Bonds

When voters are asked at an election to approve a bond measure to pay for construction at a school district or community college district, they generally have been told that a “Yes” vote will authorize the sale of general obligation bonds to fund that construction.

California educational districts are issuing two kinds of general obligation bonds: Current Interest Bonds and Capital Appreciation Bonds. Usually the district does not tell voters what kind of general obligation bonds it will sell, unless it specifically passes a resolution before the election stating it will not sell Capital Appreciation Bonds and includes that condition in the ballot statement.

1. Current Interest Bonds (also called Fixed Rate Bonds)

These are the “traditional” kind of municipal bonds. A buyer of Current Interest Bonds gets a periodic interest payment (usually semi-annually). When the bond matures, the buyer gets the principal back.

2. Capital Appreciation Bonds (also called Zero Coupon Bonds)

A buyer of Capital Appreciation Bonds does not receive semiannual or other periodic interest payments. Instead, the buyer receives all of the interest – compounded over the length of maturity for the bond – together with the principal when the bond matures. There is no regular payment of interest, but the accumulated (“accreted”) interest is compounded over many years, making the wait a worthwhile investment. Capital Appreciation Bonds are purchased at a deeply discounted amount from their face value.

Capital Appreciation Bonds are discussed in more detail in Section 5.

Two Costs to Educational Districts of Borrowing Money Via Bonds

From the perspective of the school district, the additional financial cost of borrowing money by selling bonds as opposed to spending money from the district general fund results from (1) interest and (2) transaction fees.

Interest

If someone borrows $1000 for five years from a lender at an annual interest rate of 5 percent, the borrower and the lender agree that the borrower will pay back the $1000 over five years and also pay 5% of that $1000 ($50) multiplied by five years for a total of $1250. The borrower gets the $1000 immediately to use, and the lender earns annual interest income of $50 over five years for a total of $250. Both parties consider themselves to get a benefit from the transaction.

Likewise, if a school district issues a traditional $1000 Current Interest Bond at an annual interest rate of 5 percent with a five-year term of maturity and an investor buys the bond at its face value of $1000, the school district gets the $1000 immediately to use for construction, and the investor earns annual interest income of $50 over five years for a total of $250. When the five years are over, the investor gets the $1000 back. Both parties get a benefit from the transaction. In addition, the investor does not have to pay taxes on the interest.

School districts usually sell series of bonds as a package with different maturities and interest rates.

Transaction Fees (Issuance Fees)

Bond buyers are not the only party to make money from bonds issued by California school districts and community college districts. Similar to taking out a mortgage, a variety of parties in the financial services industry are involved in the preparation and sale of bonds, and each party gets a fee for participating in the transaction. These fees are classified as “costs of issuance.”

To prevent these fees from cutting into the amount of money authorized by voters for construction, educational districts routinely inflate the interest rates on bonds they sell so that the price is higher than the face value of the bond. After the bonds are sold, that extra money, or “premium,” is used to pay the costs of issuance.

Table 8: Types of Issuance Fees
underwriter’s discount
bond counsel fees
disclosure counsel fees
paying agent fees
escrow agent fees
rating agency fees
bond insurance fees
verification agent fees
financial advisor fees
printing fees
other miscellaneous expenses

How are Municipal Bonds Bought and Sold? Who Buys Them?

Municipal bonds are not traded on an exchange like stocks. Instead, investors buy and sell bonds “over the counter” through dealers and brokers registered with the Municipal Securities Rulemaking Board (MSRB), a self-regulatory organization overseen by the U.S. Securities and Exchange Commission. These dealers and brokers act as underwriters or intermediaries between issuers and investors. They charge fees, or “mark-ups” for the transactions.

Once a school district sells a bond, the bond can be traded in the municipal bond market. The price will fluctuate and investors will be concerned about yield — the amount of income earned as prices rise and fall.

According to Federal Reserve statistics, individual investors hold a little more than two-thirds of municipal bonds, about 42 percent directly and about 28 percent through mutual funds and other investment vehicles. Major institutional investors include asset management firms, insurance companies, and commercial banks.

One of the arguments to cap or eliminate the federal tax exemption for income from municipal bonds is that the exemption mainly benefits wealthy individuals who buy bonds as a tax-exempt investment. Buyers of municipal bonds do not generally “keep the money in the community” because they aren’t in the community. And they generally do not buy bonds issued by educational districts to “help the children” or “provide vocational training to veterans.” They buy them to make money.

Ironically, the same Progressive activists who call for higher taxes on the rich also tend to support educational bond measures that help the rich to earn investment income that is tax-free. Forcing the rich to pay taxes on income earned through municipal bonds could collapse the demand for these bonds and make borrowing money for construction a much more expensive proposition for school and college districts.

Table 9: Some Advantages for Investors in Municipal Bonds
Interest earned on municipal bonds is usually exempt from federal and state income tax.
In the case of general obligation bonds, principal and interest are secured by the full faith and credit of the issuer and usually supported by either the issuer’s taxing power. Despite negative nationwide publicity about a relatively small number of bankrupt local governments (such as the California cities of Vallejo, Stockton, and San Bernardino), a government defaulting on municipal bonds is “extremely infrequent,” according to Moody’s. They are thus a relatively safe investment.
In the case of Current Interest Bonds, investors get a regular interest payment, usually semi-annually. There is a regular, dependable income stream.
In the case of Capital Appreciation Bonds, investors can earn a substantial amount of interest over a long period of time through compounding while still enjoying the relatively safe investment of general obligation bonds.

How Does an Educational District Pay Back the Borrowed Principal Plus Interest on Bond Sales?

People pay back the principal and interest on car loans, school loans, and mortgages using their income. Educational districts pay back the principal and interest on bonds using their “income,” that is, taxes collected from property owners in the district.

After a school district or community college district borrows money by selling bonds for construction, it informs the county auditor and county treasurer/tax collector. Based on the assessments of property value determined by the county assessor, the county treasurer calculates the appropriate tax rate and generates individual tax bills for owners of property such as houses, farms, apartment buildings, commercial buildings, manufacturing facilities, business infrastructure, and undeveloped land. A specific rate and tax for each bond measure is listed on the tax bill.

These taxes are called ad valorem taxes. Ad valorem is Latin for “according to worth” and indicates that taxes are levied (imposed) on property owners in proportion to the assessed value of their property.

Does Renting or Leasing Mean That You Don’t Pay for Educational Construction or the Cost of Borrowing Money for It?

Households that rent property or businesses that lease property do not pay property taxes directly. However, it is not true to claim or think that renters or lessees don’t have to pay for educational construction and the costs of borrowing money to pay for that educational construction. Property owners can and do incorporate the cost of their property taxes into their rents or leases. Bond sales by a school or college district may result in higher rent.

Technical Definitions of Bonds

Notice that the common term in all of these definitions is debt. When a school or college district sells bonds, it borrows money from investors and must pay them the money back over time, with interest.

Table 10: Technical Definitions of Bonds
SourceDefinition
California Education Code Section 15140.5 (added to law by Assembly Bill 182 in 2013)Evidence of indebtedness payable, both principal and interest, from the proceeds of ad valorem property taxes that may be levied without limitation as to rate or amount upon property subject to taxation by the governing board of the school district or community college district.
Glossary on the Municipal Securities Rulemaking Board (MSRB) websiteThe written evidence of debt, which upon presentation entitles the bondholder or owner to a fixed sum of money plus interest. The debt bears a stated rate(s) of interest or states a formula for determining that rate and matures on a date certain.
U.S. Securities and Exchange Commission website definition of municipal bondsDebt securities issued by states, cities, counties and other governmental entities to finance capital projects, such as building schools, highways or sewer systems, and to fund day-to-day obligations. Investors who buy municipal bonds are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” The date when the issuer repays the principal, the bond’s maturity date, may be years in the future. Short-term bonds mature in one to three years, while long-term bonds generally will not mature for more than a decade. 
Internal Revenue Service Tax-Exempt Governmental Bonds Compliance Guide description of municipal bondsTax-exempt bonds are valid debt obligations of state and local governments, commonly referred to as “issuers” - the interest on which is tax-exempt. This means that the interest paid to bondholders is not includable in their gross income for federal income tax purposes. This tax-exempt status remains throughout the life of the bonds provided that all applicable federal tax laws are satisfied…Governmental bonds are tax-exempt bonds issued by a state or local government, the proceeds of which are generally used to finance activities or facilities owned, operated, or used by that or another government for its own purposes. This can include financing the building, maintenance, or repair of various types of public infrastructure such as highways, schools, fire stations, libraries, or other types of municipal facilities.

Sources

“Statement on Making the Municipal Securities Market More Transparent, Liquid, and Fair,,” U.S. Securities and Exchange Commission, February 13, 2015, accessed June 28, 2015, www.sec.gov/news/statement/making-municipal-securities-market-more-transparent-liquid-fair.html

“Letters to Congress/Administration,” National Association of Bond Lawyers, accessed June 28, 2015, http://registration.nabl.org/about/Governmental-Affairs/Tax-Reform-Resources/Letters-to-Congress-Administration.html

California League of Bond Oversight Committees (CalBOC) www.calboc.org

Reuters “MuniLand” blogger Cate Long blogs.reuters.com/muniland/

The Bond Buyer www.bondbuyer.com

Municipal Securities Rulemaking Board (MSRB) www.msrb.org

Board of Governors of the Federal Reserve System – Data Releases, June 11, 2015, accessed June 28, 2015, www.federalreserve.gov/releases/z1/current/z1r-4.pdf

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