Report 2011-118/2011-613 Summary - August 2012

Conduit Bond Issuers:

Issuers Complied With Key Bond Requirements, but Two Joint Powers Authorities' Compensation Models Raise Conflict-of-Interest Concerns

HIGHLIGHTS

Our audit of the organizational structures and significant policies and practices of two joint powers authorities (JPAs) and the California Health Facilities Financing Authority (Health Financing Authority) highlighted the following:

  • Although the compensation model of the two JPAs raises concerns, we cannot conclude that it violates California's conflict-of-interest laws.
    • Public officials, including consultants performing the work of public officials, are prohibited from making, participating in, or attempting to influence certain governmental decisions in which they have a material economic interest.
    • The two JPAs rely wholly on private consulting firms for staff and pay them a percentage of the fees associated with each conduit financing.
    • Consultants who advise the JPAs believe that a 1993 advice letter from the Fair Political Practices Commission (FPPC) applies to their circumstances and that they have not violated laws.
    • No court has squarely addressed the legality of this compensation model.
  • The two JPAs could improve their contracting practices to better ensure contractors' fees are reasonable.
    • The two JPAs have not required their consulting firms to compete against other firms since their respective formations in 1988 and 2004, and thus, have less assurance that they are getting the best value.
    • Because they pay their consultants based on a percentage of the fees associated with bonds issued, JPAs risk receiving advice that may not be in their best interest.
  • The Health Financing Authority and the two JPAs all issue conduit revenue bonds in accordance with key federal and state laws, and substantially complied with reporting requirements.

RESULTS IN BRIEF

Many public agencies issue conduit revenue bonds on behalf of private businesses or nonprofit organizations (borrowers). Once investors purchase the bonds, borrowers use the resulting proceeds to fund projects that provide public benefits, including hospitals, affordable housing, and pollution control facilities. Because these projects further public purposes, the interest that bond investors receive is generally exempt from state and federal income tax. The public agencies that issue the bonds are not responsible for paying the investors back; rather, they merely serve as a conduit connecting borrowers to investors. In return for serving that purpose, the agencies charge the borrowers fees that vary depending on the size and the nature of the projects.

In this audit we evaluate whether the organizational structures and significant policies and practices of three public agencies that issue conduit revenue bonds (issuers) comply with applicable laws and other requirements. The California Health Facilities Financing Authority (Health Financing Authority) is a state entity administratively located within the State Treasurer's Office, while the California Statewide Communities Development Authority (California Communities) and the California Municipal Finance Authority (Municipal Finance) are joint powers authorities established under the California Joint Exercise of Powers Act (joint powers act). Each of these three issuers is governed by a board of directors that votes to approve issuances at public hearings.

Although we found that the compensation model of the joint powers authorities raises concerns, we cannot conclude that it violates California's conflict-of-interest laws. Unlike the Health Financing Authority, both California Communities and Municipal Finance rely wholly on private consulting firms for staff. Because the joint powers authorities pay these consulting firms a percentage of the fees associated with each conduit financing, there is a concern as to whether this practice violates the Political Reform Act of 1974 (political reform act). This act prohibits public officials—in this case, consultants performing the work of public officials—from making, participating in, or attempting to influence certain governmental decisions in which they have a material economic interest. The consultants believe that a 1993 advice letter published by the Fair Political Practices Commission (FPPC), which administers the political reform act, applies to their circumstances. If so, they have likely not violated the act. However, neither the FPPC nor a court of appropriate jurisdiction have ever considered the applicability of the reasoning set out in that advice letter, known as the McEwen advice letter, to the specific circumstances here. Moreover, given that consultants who advise public entities widely rely on the reasoning set out in the McEwen advice letter, it may be helpful for the Legislature or the FPPC, as appropriate, to provide clear policy direction.

The joint powers authorities' use of consultants also raises concerns under another state conflict-of-interest law. Specifically, California Government Code, Section 1090 (Section 1090), prohibits public officials and employees from having a financial interest in any public contract whose formation or approval they participate in. Because the consultants here act in the same capacity as public employees, we believe they are subject to the prohibition contained in Section 1090. Further, we believe that the consultants' role in the bond approval process constitutes participating in the formation of a contract for the purposes of Section 1090. Although there is some case law that suggests that consultants who contract with public entities may be paid on a contingency fee basis without violating Section 1090, no court has squarely addressed the specific question presented here and we cannot reach a definitive legal conclusion.

In addition, California Communities and Municipal Finance could improve their contracting practices to better ensure contractors' fees are reasonable. The boards of directors for the two joint powers authorities have not required their consulting firms to compete against other firms since the joint powers authorities were formed in 1988 and 2004, respectively. By not periodically bidding out the contracts for these services, or performing some other price comparison analysis, the joint powers authorities have less assurance that they are getting the best value from their consultant contracts. Moreover, by choosing to pay the consulting firms a percentage of the fees associated with bonds issued, the joint powers authorities create a financial incentive for consultants to recommend the approval of bond issuances. Further, they do not mitigate this financial incentive by requiring the consulting firms to disclose whether they compensate their employees in a way that is directly tied to the number or volume of bonds the joint powers authorities issue.

In evaluating the issuers' compliance with other laws and requirements, we found that the Health Financing Authority, California Communities, and Municipal Finance, all issue conduit revenue bonds in accordance with key federal and state laws. For example, the issuers ensure that the projects they finance meet state and federal requirements for tax-exempt financing related to the public benefits the projects must provide. Moreover, the issuers provide additional benefits to communities throughout the State either by distributing fee revenues to the jurisdictions in which projects are located or by contractually obligating borrowers to serve specified public purposes.

In our review, we also found that the issuers substantially complied with reporting requirements. Effective January 1, 2010, Chapter 557, Statutes of 2009 (Senate Bill 99 (SB 99)) created requirements to ensure that conduit financing providers make their activities transparent and accountable to the public by extending opportunities for participation in public meetings and by providing information about their financial activities. While the Health Financing Authority and Municipal Finance met the applicable SB 99 requirements, California Communities did not provide all necessary disclosures in its financial statements for fiscal years 2009-10 and 2010-11. However, once we alerted California Communities to this oversight, it updated its financial statements to include this information. We also found that before fiscal year 2006-07, California Communities did not prepare and file audited annual financial statements as required by the joint powers act. However, it has prepared the statements each year since that time.

In evaluating other aspects of the issuers' practices, we noted that borrowers' bankruptcies and other financial disclosures are not generally an accurate measure of an issuer's performance. We have no reason to believe that any of the issuers we reviewed are better than the others in regards to the quality of bonds they issue. We also concluded that although issuers may charge different fees for similar services, this variance is not inherently problematic because borrowers can analyze these fees and select the issuers that best meet their needs.

RECOMMENDATIONS

If the Legislature believes that the compensation model is appropriate whereby the private firms that employ consultants are paid a percentage of the fees associated with bond issuances, the Legislature should enact legislation that creates a clearly stated exemption from Section 1090. On the other hand, if the Legislature believes that this compensation model is not appropriate, it should enact legislation that clearly proscribes, or limits, such a model.

The FPPC should adopt regulations that clarify whether the analysis in the McEwen advice letter is intended to apply to the factual circumstances presented in this audit.

To be better informed about the compensation of their consultants, including any potential conflicts of interest, California Communities and Municipal Finance should require the consulting firms that staff their organizations to disclose the amount and structure of compensation provided to individual consultants, including disclosing whether any of this compensation is tied to the volume of bond sales.

In implementing its January 2012 contracting policy, California Communities should either periodically subject existing contracts to competitive bidding or perform some other price comparison analysis to ensure that the public funds it oversees are used effectively.

Municipal Finance should follow its July 2012 policy that describes how it will select contractors and periodically review existing contractors' services and prices to ensure the public funds it oversees are used effectively.

AGENCY COMMENTS

The Health Financing Authority, Municipal Finance, and California Communities concurred with our conclusions and recommendations.


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