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MONTHLY NEWSLETTER:  MARCH 2010 ISSUE

AN ERIN BROCKOVICH MOMENT
BY BRENT VAN ALFEN
PROVIDENCE FINANCIAL CO., LLC



Most of us are familiar with the movie which dramatizes a real life story of Erin Brockovich who uncovered some serious wrong doing by a major corporation. Her tenacity in the face of huge odds against her and the wrongdoing she uncovered have made her famous. I recently reviewed a bond financing of a charter school. While not rising to the level of the injustice Brockovich found, it certainly reminded me of the story.

As you read the following, keep in mind that an underwriter must create a bond with terms that investors will accept in addition to negotiating a coupon (interest) rate that will attract enough investors to sell the bonds. It is a balancing act between the needs of the borrower and the investor wherein a good underwriter will make every effort to be fair to both, as it is essentially a zero sum game. The reality is, however, that underwriters do business with investment firms on a continuous basis for years while they will likely only deal with a charter school on one financing. This provides fertile ground for some underwriters to take advantage of charter school managers, board members, and their attorneys and accountants who are not sophisticated enough to defend their own interests.

Here is a real-world case in point. The school I referred to above may not borrow any additional debt in excess of an aggregate amount of $200,000 during the 30-year term of the bonds without the consent of the majority of the bondholders. That includes debt for any purpose. I don’t need to explain how restrictive that is and the future problems it could cause.

The school covenants to obtain an investment grade rating for the currently outstanding bonds at the school’s expense and on the school personnel’s time whenever the bondholders direct them to do so. This is a laborious, expensive process that benefits only the investors – not the school.

The key founders and managers of the school covenant not to open another, potentially competing school, for a period of five years within a ten mile radius. The bondholders are the ones who decide if another campus will be allowed under this restriction – not the school personnel. This option is taken away from the school management.

Issuing additional bonds for additions or improvements to the facility or for building another campus may not be done without the approval of the majority of the bondholders. On the surface, this does not seem unreasonable until you think about some of the ways this restriction can come back to haunt you. An example follows.

Many underwriters and even attorneys will tell the uninformed that there is no prepayment penalty in a tax-exempt bond issue’s covenants. TECHNICALLY, they can rationalize that they are telling the truth. But there is almost always a “no call” provision in the bond covenants that prohibits “calling” or “refunding” the bonds for as long as ten years. If the school “calls” or “refunds” the bonds within that ten-year period, there is an “advance refunding” expense that is generally prohibitively expensive except under certain circumstances. What is the old saying about a rose that still smells the same?

It is tempting for the reader to believe that these concerns and restrictions are perhaps ominous but understandable--and they will never affect me anyway. Well, here is how it affects, at least in part, the school that is the subject of this article.

They had bonds issued for them about three years ago when they thought their new facility would be more than adequate for their needs. Since then, their educational style and the success of their students has created demand for a high school for their students to continue through twelfth grade. They received approval for an expanded charter and located a nice piece of property about a mile from their current campus. Now all they had to do was call their underwriter and have them arrange for another bond offering….right? Wrong! What they had no way of knowing at the time is that one investment firm bought all of their original bonds at an interest rate of about 6.25% (the good old days). The school cannot incur new debt of any kind, including bonds, without the investor’s approval. Therefore, the investor has the leverage needed to buy that new debt if they so choose--on terms they dictate--or they can stop the expansion entirely. Well, at least there is no prepayment penalty – right? The school can just pay off the current bonds and enter into a new bond offering for both campuses. Unfortunately, the costs associated with defeasance on the present, low-interest bonds, plus the additional cost of a higher interest rate in today’s market will be nothing short of horrendous. We are talking hundreds of thousands of dollars. The school may have no practical way of financing the new campus without an almost crippling amount of expenses. The fallback solution then might be to form a new business entity and get a new charter in that name to build the high school – right? Wrong! There is the non-compete clause described above that will prevent this.

When entering into the complex charter school facility financing market, it is well worth it to get an experienced financial advisor who has no conflicts of interest. Had this school done so, their circumstances may be very different. Please give us a call if you have questions

For information contact Brent Van Alfen, Providence Financial Co., LLC
Phone: 801-299-8555 Email: brent@providencefinancialco.com






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