href="http://www.metrocorpcounsel.com/current.php?artType=view&EntryNo=2623">Part
II of this article dealing with federal laws and legal opinion issues will
appear in the April 2005 issue of
The Metropolitan Corporate
Counsel.
Private developers have successfully gained access to the capital markets
to finance the acquisition, development and construction of commercial
properties for lease to the Federal government or its vendors. These
transactions involve the issuance of securities backed principally by the stream
of lease or similar payments to be made by the federal government and bring
about a unique intersection between the private sector - private developers,
lenders, monoline bond insurers and the capital markets - and the Federal
government. This article briefly explores some of the issues and risks to be
addressed in this type of financing.
Overview Of The Market Place
We have participated in a growing number of government lease-backed and
service contract-backed securities transactions, either as counsel to the
developer, the placement agent for the securities or the insurer of the
securities. Projects have included the financing, construction and equipping of
federal courthouses, post offices, office and research facilities and equipment
and service contract arrangement for various agencies of the federal government,
including facilities operated by contractors for the federal government and its
agencies. As of March 2002, Standard & Poor's Ratings Services reported that
it had issued ratings on more than 30 of such transactions.1
Financing Structure
In a typical securitized government lease transaction, a private
developer forms a special purpose entity (SPE) to acquire either fee title to or
a long-term ground leasehold interest in the property on which the project will
be built. In many cases the SPE then leases the facility directly to the
governmental user. In other cases, however, the SPE enters into a prime lease
with a third party, pursuant to which the SPE agrees to construct the facility
and lease it to the third party upon completion of construction. The third
party, in turn, will enter into a sublease with the federal government or in
some cases with an entity providing services to the federal
government.2 The prime lease generally will provide that,
after completion of the project and acceptance thereof by the federal government
(or its contractor pursuant to the sublease), the rental obligations under the
prime lease are limited to a specified portion of the payments to be made by the
federal government or its vendor under the sublease.
To finance the construction of the project, the SPE directly or
indirectly will issue securities that are debt obligations secured by, among
other things, the lease payments or other payments to be made under the
government sub-lease or service contract. The securities generally are issued in
private placements under Rule 144A and sold to institutional investors. In
addition to its pledge of the rental or service contract payments to be made by
the government user of the project, the SPE generally will grant a mortgage (or
leasehold mortgage) on the SPE's interest in the property for the benefit of the
securities holders. The rents or service contract payments under the subleases
or leases are generally structured to be sufficient to meet the debt service on
the securities, plus operating and maintenance expenses of the project,
including real estate taxes (where relevant), insurance and certain reserve
requirements set forth in the documents governing the transaction.
Non-Appropriation Risk And Related Rating And Credit Enhancement Issues
The rating agencies and any credit enhancer of such indirectly
government-backed securities must assess the credit quality and security of such
a transaction. Any such assessment begins with the nature of the government's
obligation to make payments under the lease or sublease or to pay its service
provider under the applicable service contract. In the most favorable scenario,
the government's obligation to pay rent (or to pay or reimburse the service
provider for rental payments under the sublease) is a fully appropriated,
unconditional general obligation of the federal government, backed by its full
faith and credit. Many GSA leases fall into this category. In such cases, the
lender and the rating agencies will require counsel to provide a legal opinion
to such effect. These types of transactions generally receive ratings of "AA" or
higher, based on the credit strength of the federal
government.3
In more and more cases, however, the obligation of the government under
the lease, sublease or service contract is conditional, subject to termination
in subsequent years. A typical grounds for termination is the lack of budgetary
appropriation by the United States Congress.4 Under certain
scenarios, the government may also terminate a contract "for convenience," or
for any reason, not simply for lack of appropriated funds, and in these cases
various termination remedies may be available to the vendor. In the event of
non-appropriation, the government typically may terminate the lease upon one
year's notice and, except for payments to be made under credit enhancement or
other amounts available under the documents securing the indebtedness, no funds
may be available after such termination to make the payment of debt service on
the securities. The lender or credit enhancer must scrutinize this type of
transaction to determine the nature of the non-appropriation risk and the
"essentiality" of the project - i.e., that the project serves an essential
governmental function that mitigates against the risk of
non-appropriation.5
Certain credit enhancers will underwrite non-appropriation risk for a
fee.
In the event of termination of the lease for non-appropriation or any
other reason, the lender and/or the lessor under the lease must have the ability
to obtain possession of the premises, and to exercise remedies such as
foreclosure and/or re-letting of the project. The credit analysis must take into
the account the market value of the facility in the event of foreclosure and
sale to a third party, including the likelihood that the facility could be used
for non-governmental purposes. Additional considerations may include the sizing
of reserves to meet debt service or other obligations pending sale or re-letting
to a third party or during periods when rent is interrupted, such as government
shutdowns. Because the lender will not want to rely on the remedial provisions
alone, the lender should be comfortable in a transaction involving
non-appropriation and termination risk that the government will have little
incentive to terminate the lease - e.g., because of the essentiality of the
facilities, the cost or time required to relocate the functions elsewhere, or
the rights or assets that the government otherwise would lose by terminating the
lease. For example, in a recent transaction with an Executive Department, the
Department agreed, among other things, that its right to repurchase the
facilities at the end of the lease term for a nominal amount would lapse if it
directed its contractor to terminate the sublease or failed to appropriate.
Normal Lease Provisions vs. Securitization Lease
Certain provisions of a normal GSA lease ordinarily must be modified in
order to facilitate securitization. These provisions include, among other
things, waiver or modification of the rights of offset and recoupment, the
establishment of a firm commencement date of the term of the lease, and
modifications to the normal right of a governmental tenant to terminate the
lease after the occurrence of a casualty, although some credit enhancers will
accept some or all of these limitations.6
Offset and Recoupment
In the event the landlord under a government lease fails to perform its
obligations under any separate agreement with the government, the Government
normally has a right to offset such claims against its rent obligation.
Similarly, if the landlord defaults under the lease itself, the government may
deduct ("recoup") the cost of remedy or repair against future rent. In order to
facilitate securitization, however, the government often will agree to limit its
right of recoupment to a specific dollar amount - e.g., 2% of the annual rent
payable in a specified offset period.7 In certain other
transactions, the government has agreed that the rent shall not be subject to
offset, recoupment, abatement or reduction at all, for any reason, except for
certain mistakes in pricing criteria (such as failure to deliver the agreed upon
net usable square footage) or, after a casualty, during any period when the
premises are unusable by the tenant.
Lease Commencement Date
In the normal GSA lease, the government's obligation to pay rent
commences when the facility is delivered and accepted by the government as
substantially complete. However, in securitization transactions, the government
lessee may agree that its obligation to pay rent shall commence on a fixed date,
whether or not the project is then substantially complete. The fixed date
generally is scheduled to coincide with the end of the anticipated construction
period and the period when any capitalized interest funds available to pay debt
service on the securities are expected to be exhausted. Generally, even with
date-certain leases, if they are subject to cancellation by reason of
non-appropriation the purchasers of the securities and the credit enhancer will
not want to take the risk that the facility will not be timely constructed
because such a circumstance increases non-appropriation risk. To mitigate
construction risk, payment and performance bonds will be required of the
contractors and liquidated damages for late delivery may be required.
Casualty Provisions
In the normal government lease, complete destruction of the premises by
fire or other casualty will result in immediate termination of the lease, and
partial destruction or damage that renders the premises untenantable in whole or
in part will give the government tenant the right to terminate the lease upon
notice to the lessor; however, the normal government lease gives an open ended
time to the government in which to exercise this termination option. If
terminated, no rent would accrue after the termination; if not terminated, the
rent would be proportionately reduced. These provisions present the risk that,
after a casualty, the government could delay its election to terminate the lease
beyond the period of any rent loss insurance provided, resulting in an
interruption in the rental stream necessary to pay debt service on the
securities.
To deal with this risk in a securitization transaction, the lease is
often modified to remove any immediate termination of the lease upon a casualty
and to limit the time during which any right on the part of the government to
elect to terminate the lease may be exercised. The lease should provide that, in
the event of casualty, the landlord will be obligated to repair the damage and
restore the facility to substantially the same condition as before the casualty,
and the government either will not have the right to terminate the lease or, if
it does have the right to terminate the lease, it may do so only if the landlord
notifies the government that the repair and restoration cannot be completed
within a specified time period (e.g., 270 days from the date of casualty). The
rental payable under the lease may be proportionately reduced during any period
when the premises are not tenantable; however, to address the risks of casualty
and reduction in rents during restoration of the facilities, the landlord
typically is required to obtain rental interruption insurance sufficient to pay
rent for the applicable period (to provide a replacement source of revenue in
the event the rent payable by the government is abated). The landlord will also
be required to obtain casualty insurance in an amount equal to the replacement
value of the facility. In some cases the landlord has been given the right to
elect not to repair or restore the damage if the casualty occurs during the last
two years of the lease term. If the landlord exercises such right not to repair
or restore the damage, the proceeds of casualty insurance should be applied
first to pay the outstanding principal amount of the securities.
Lease Term
GSA lease terms are usually 5 to 10 years, although some leases may be as
long as 20 years. Because the rents that can be offered are much lower if the
term of the debt to be paid out of the rents is amoritized over 25 years or
longer, the bondholder or credit enhancer has a keen interest in renewal
provisions. Typically in a GSA lease, the government must take affirmative
action to renew; however, from the lender's point of view, the notice period for
renewal should be as long as possible, e.g., not less than a year prior to the
renewal date, to allow sufficient time for the parties to obtain a new tenant or
pursue other options if the government does not renew. As an underwriting
matter, the credit enhancer must assess the risk of nonrenewal of the lease and
the ability to recover the unpaid principal balance of the securities in the
event of such non-renewal, either through re-letting or sale of the facilities.
In one recent transaction in which we were involved, the documents provided
that, if the government fails to renew its sublease, the third party tenant
under the prime lease is obligated to make an agreed upon lump sum payment to
the landlord under the prime lease (i.e. the SPE) in partial reduction of the
principal balance of the securities scheduled to be outstanding on the lease
expiration date.
1"Securitized Federal Leases Revisited,"
reproduced with the permission of Standard & Poor's Ratings Services, a
division of The McGraw-Hill Companies, Inc., in Tax-Exempt Leasing Letter,
a publication of the Association for Governmental Leasing & Finance,
Washington, D.C., on March 4, 2002.
2In
transactions in which the facility being financed is managed or operated by a
vendor to the government, the sublease is entered into by the vendor. The rent
payable by the vendor under the sublease is a reimburseable expense payable by
the government.
3"Securitized Federal Leases
Revisited," described at note 1, supra.
4
See discussion of the Anti-Deficiency Act hereinbelow.
5Generally, non-appropriation
risk for federal leases falls into two categories: functional appropriation risk
and line item appropriation risk. In the case of functional appropriation, the
obligation is subject to an appropriation by Congress for a particular category
of spending or a specific program function (such as military housing), and the
risk is that Congress will not make such an appropriation. So long as Congress
appropriates funds for that category of expenditures or function, however, the
government is obligated to make the lease payments under the lease unless the
Congressional appropriation contains specific language stating that a particular
lease or class of leases are not to be paid. For example, in a transaction
involving the lease of a facility operated by a operations and maintenance
contractor for a particular Executive Department, the government was obligated
to make payments to the contractor in respect of rent so long as Congress made
an appropriation to the general operating expenses budget of that Department
from which budget operating expenses, including certain reimburseable
expenses for lease payments, may be made.
In the case of the Congressional line item appropriation, Congress must
make an appropriation for the specific lease. Evaluating the risk such a
transaction involves requires a determination not only that the program is
essential, but also that the program must be carried out at the site in
question. This requires a much higher level of Congressional deference to the
Executive, and thus carries a greater risk of non-appropriation. Because
demographics, cost structures and needs change, this type of appropriation
presents greater risks, so the analysis of "essentiality" is very important.
6If the SPE owns a leasehold interest in
the property and the securities are secured by a leasehold mortgage, the lender
must ensure that the ground lease contains normal lender protections intended to
prevent a termination of the ground lease while the indebtedness is outstanding,
including the right to cure defaults by the SPE under the ground lease, and the
right to obtain a "new lease" from the ground lessor in certain circumstances.
7 In one transaction in which we have been
involved, the offset period was defined as the period commencing on the date of
the commencement of the right of offset and ending on the earlier of (i) the
fifth anniversary of the commencement of such offset period and (ii) the
termination of the lease.
Published March 1, 2005.
