Part I of this article appears in the March 2005 issue of The Metropolitan Corporate Counsel.
Federal Laws And LegalOpinion Issues
As part of its due diligence, counsel involved in the securitization of a government lease or service contract obligation should determine that the transaction complies with various federal laws that are unique to the federal government and its agencies, and assess the impact on the transaction of such laws. Among these federal laws are those commonly known as the Anti-Deficiency Act, the Federal Buildings Act, the Anti-Assignment Acts and the Prompt Payment Act.
Anti-Deficiency Act
Federal agencies are generally prohibited from obligating funds under a contract or lease unless an appropriation has been made by the United States Congress to cover such obligation. This prohibition is referred to generally as the "Anti-Deficiency Act" and is set forth in 31 U.S.C. 1341, among other federal laws providing limitations on government obligations. The Anti-Deficiency Act generally prohibits federal agencies from (i) making expenditures in excess of amounts appropriated for such expenditures and (ii) obligating funds under a contract or lease before an appropriation to cover such obligations is made. Since appropriations generally are made annually, multi-year leases that are not fully appropriated, general obligations of the federal government must be scrutinized to determine whether they violate the Anti-Deficiency Act. Leases by agencies for terms in excess of one year have been found not to violate the Anti-Deficiency Act if they contain a clause allowing the agency to terminate the lease due to lack of appropriated funds in the out years. Aerolease Long Beach v. United States, 31 Fed.Cl. 342 (1994). However, some agencies, citing the Anti-Deficiency Act, have required that leases entered into by the agency and its contractors include a provision allowing the agency to terminate the lease for any reason, not simply for lack of appropriated funds.
For purposes of compliance with the Anti-Deficiency Act and other budgetary considerations, a federal agency may require as a condition to its obligation to enter into a lease a determination that the lease will be treated as an operating lease, and not a capital lease, under accounting principles applicable to federal agencies. Congress and OMB agreed on the scoring requirements for leases in the Budget Enforcement Act of 1990 (BEA) and rules promulgated pursuant thereto. These rules are set forth in OMB Circular No. A-11 (2003) in Appendix B - Scoring Lease-Purchases and Leases of Capital Assets, and require that six criteria be met in order for a federal lease to be considered an operating lease. If any of the criteria are not met, the lease will be scored as a capital lease and the net present value of the total cost of the lease, for the entire term of the lease (including any option periods) will be scored as budget authority (i.e., applied against currently available appropriated funds) in the year budget authority is first made available for the lease. If the lease meets all six criteria, it is scored as an operating lease and only the budget authority needed to cover the annual payment is required to be scored.
The six criteria set forth in Circular A-11 for an operating lease are as follows:
1. Ownership of the asset remains with the lessor during the term of the lease and is not transferred to the government at or shortly after the end of the lease term;
2. The lease does not contain a bargain-price purchase option;
3. The lease term does not exceed 75 percent of the estimated economic life of the asset;
4. The present value of the minimum lease payments over the life of the lease does not exceed 90 percent of the fair market value of the asset at the beginning of the lease term;
5. The asset is a general purpose asset rather than being for a special purpose of the government and is not built to the unique specification of the government as a lessee; and
6. There is a private sector market for the asset.
Under these rules, a provision in a lease allowing an agency to terminate the lease for lack of appropriated funds would not be sufficient in itself to meet the standard of an operating lease.
Federal Buildings Act
The Federal Property and Administrative Services Act of 1949 (sometimes called the "Federal Buildings Act") governs all property transactions of the federal government. Under this Act, the Administrator of the GSA is expressly authorized to enter into leases for a period not to exceed 20 years. However, other agencies may have independent contracting authority or may not have express contracting authority and diligence as to the legality of such transactions is thus required. The Act and related regulations also provide for specified forms of leases. Counsel to the GSA or other contracting agency of the government should be asked to render a legal opinion to the effect that the lease is authorized by the Federal Buildings Act or other applicable law, that no other authorizations or approvals are required in connection with the execution and delivery of the lease, and that any change in any provision contained in the lease from the form required under any statute or regulation has received all requisite authorizations and approvals necessary to cause the change or variation to be legal, valid and binding on the United States.
Anti-Assignment Acts
There are two "anti-assignment" statutes applicable to federal government contractors: the Assignment of Contracts Act, which prohibits the transfer of government contracts or interests in government contracts, and the Assignment of Claims Act, which prohibits the assignment of claims or interests in claims against the government. These laws operate to invalidate transfers of government contracts (including leases) or claims against the government by assignees. These statutes were enacted so that the government would always be able to "deal exclusively with the original claimant" and would always be aware of its obligations.
Recognizing the need for government contractors to obtain private financing to perform their contracts, Congress amended the statutes to include a "financing institutions" exception to the bar on assignments. Financing institutions for this purpose are defined to include "a bank, trust or other financing institution, including any Federal lending agency." The financing institution exception requires the satisfaction of certain requirements: the contractor must duly execute an instrument of assignment, and the assignee must give written notification of the assignment, together with a true copy of the instrument of assignment, to the contracting officer or agency head, to the surety on any bond applicable to the contract and to the disbursing officer designated to make payment.
In a government lease securitization, the assignment of the lessor's right to receive lease or contract payments from the government is the primary security for the indebtedness. Accordingly, care must be taken to ensure that procedures satisfying the requirements of the financing institutions exception of the Assignment of Claims Act are followed. In addition to any pledge of the lessor's rights to such payments to the trustee for the benefit of the security holders under the trust indenture, the SPE generally will execute a separate instrument of assignment in favor of the trustee (or an institutional escrow agent designated to receive such payments), and such assignee will send notice of the assignment to the applicable government agency and disbursing officer. Receipt of such notice should be acknowledged in writing by the appropriate contracting and disbursing officers. Counsel to the developer or another party to the transaction should be required to render a legal opinion to the effect that following the prescribed procedures (which should be specifically set forth in the opinion) will constitute compliance with the Assignment of Claims Act and the trustee (or other assignee) would have those rights afforded to assignees complying with the Act.
Prompt Payment Act
Pursuant to the Prompt Payment Act and the rules promulgated pursuant thereto, government agencies are required to pay their bills on a timely basis and to pay interest penalties when payments are late. The "General Clauses" incorporated into most GSA leases typically contain prompt payment provisions which provide, among other things, that rent shall be paid monthly in arrears and will be due on the first workday of each month, and only as provided for by the lease. When the date for commencement of rent falls on or before the 15th day of the month, the initial monthly rental payment under the lease will become due on the first workday of the following month. If the date for commencement of rent falls after the 15th day of a month, then the initial monthly rental payment will become due on the first workday of the second month following the month in which the rent commencement date becomes effective. The lease documents should reflect these payment dates and pro forma cash flows prepared for the transaction should reflect these rent payment dates. Payments under the lease other than rent are due on the later of the 30th day after the designated billing office has received a proper invoice from the service provider or the 30th day after the government has accepted the work or service. The government has the right to inspect and determine the acceptability of work performed or services delivered within seven days after the receipt of a proper invoice or notification of completion of the work or services.
Pursuant to the Act, an interest penalty shall be paid automatically by the government if payment is not made by the due date. The interest penalty shall be at the rate established by the Secretary of the Treasury under Section 12 of the Contract Disputes Act of 1978 that is in effect on the day after the due date. This rate is referred to as the "Renegotiation Board Interest Rate," and is published in the Federal Register semiannually on or about January 1 and July 1. The interest penalty accrues daily on the payment amount approved by the government and is compounded in 30-day increments inclusive from the first day after the due date through the payment date. Although the parties may provide for an alternative interest rate, the government agency cannot be required to pay more interest than that provided under the Prompt Payment Act.
Interest Rate Caps and Swaps
To take advantage of relatively low variable interest rates, the developer often will seek to issue variable rate securities even though the lease payments are calculated on the basis of a fixed rate and produce a fixed stream of revenues. To mitigate the risk of interest rate fluctuations, the credit enhancer may require the SPE to enter into and maintain an interest rate cap agreement with a highly rated institutional provider during any period when the securities bear interest at a variable rate. To the extent the interest on the securities is greater than the index specified in the cap agreement, payments from the cap provider should be available to make payments to the security holders. Alternatively, some credit enhancers will provide a fixed-to-variable rate swap to allow the developer to utilize synthetic variable rate debt. Conflicts may arise between the swap or cap providers and the credit enhancer supporting the financing as to priority vis-a-vis collateral, although one solution we have seen is to have payments by the SPE under the swap agreement guaranteed by a separate insurance policy issued by the credit enhancer. The SPE's rights under the swap agreement, including any related guarantee of the provider's obligations under the swap agreement, may also be assigned to the trustee for the benefit of the security holders.
Phantom Income
One further issue to be addressed is the potential recognition by the owner of the project (i.e., the SPE) of phantom income. This problem arises from the mismatch between the amortization of the debt securities and the depreciation allowable on the facility to be built. The securities typically will be amortized over a period of 25 years or more, while deductions for depreciation of the facility utilized by the government must be spread over a longer period of 40 years. As a result the owner will recognize income at a faster pace than it can claim offsetting deductions for depreciation and interest expense. This creates a potentially large income tax liability for the owner. Care should be taken to provide for the payment of any such potential tax liability in the flow of funds under the trust indenture so as to prevent any lien for such taxes that might affect the transaction. There are also several technical solutions to this problem but it may be critical to address it up front in structuring any transaction.
Conclusion
Securitization of government lease or service contract obligations provides an effective and efficient, market-driven way for developers to finance the construction of facilities intended to be used by the Federal government and its agencies. This unique cooperation between the public and private sectors to provide first class facilities for the federal government is both beneficial to the public and profitable to its private participants. However care must be taken to analyze the various risks involved and to structure the transaction in such a way that will mitigate such risks and comply with various laws that are unique to dealings with the federal government.
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.
Published April 1, 2005.
