Joseph Krist

Publisher

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ISSUE OF THE WEEK

$251,000,000

Philadelphia School District

General Obligation Bonds

The District’s debt carries an underlying Ba2 rating and an A2 enhanced rating. The underlying rating is based on strained financial position and narrow reserves, exacerbated by substantial charter enrollment pressures. As students leave the system for charter schools the District loses state revenues which are linked by formula to average daily attendance. This has been a long standing problem for the District. The trend of shift in enrollment from the public system to charter schools has slowed but is still an issue for the District and its finances.

The A2 enhanced rating reflects the credit support of the Pennsylvania School District Intercept Program, which provides that state aid will be allocated to bondholders in the event that the school district cannot meet its scheduled debt service payments. The rating reflects that Philadelphia School District has engaged a fiscal agent, and there is language in the bond documents that will trigger the state aid intercept prior to default.

The positive outlook assumes that finances will be maintained within the range of what is considered structural balance on a forward basis. Governance of the system was returned to local control in 2018. The mayor’s recent budget proposals have allocated permanent tax increases to the district.

These are general obligation bonds of the Philadelphia School District, to which the district has pledged its full faith, credit, and taxing power. The district’s GO debt is supported by a lock-box structure, whereby four dedicated tax streams (including property tax) are allocated on a daily, pro-rata basis to bondholders. The Pennsylvania School District Intercept Program is not a general obligation guarantee of the Commonwealth, and in fact, there have been times when the state has not distributed any aid to school districts, as was the case during the 2016 state budget impasse. However, with implementation of Act 85 in 2016, the state has ensured that intercept payments, for the benefit of bond debt service, will be made even in the absence of an appropriation budget.

The enhanced rating is ultimately tied to the general obligation rating of the Commonwealth. The current outlook for the Commonwealth’s rating is stable despite a difficult annual budgeting process and an excessively political environment due to the upcoming gubernatorial election in November.

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CYBERSECURITY BACK IN THE NEWS

Analysis by DHS and FBI was revealed this week that showed that since at least March 2016, Russian government cyber actors—hereafter referred to as “threat actors”—targeted government entities and multiple U.S. critical infrastructure sectors, including the energy, nuclear, commercial facilities, water, aviation, and critical manufacturing sectors. In multiple instances, the threat actors accessed workstations and servers on a corporate network that contained data output from control systems within energy generation facilities.

Russian state hackers had the foothold they would have needed to manipulate or shut down power plants. made their way to machines with access to critical control systems at power plants that were not identified. The hackers never went so far as to sabotage or shut down the computer systems that guide the operations of the plants. The report made it clear that efforts to actually shut down operations did not occur, not because of technical inability but because a conscious decision was made not to.

The groups that conducted the energy attacks are linked to Russian intelligence agencies. Affected facilities included that of the Wolf Creek Nuclear Operating Corporation, which runs a nuclear plant near Burlington, Kan. At the time of that attack in summer 2016, the corporation said that no “operations systems” had been affected and that their corporate network and the internet were separate from the network that runs the plant.

The level of disclosure available from municipal utilities as to the cyber threats they face and their response to them has varied. They range from none to very broad and inexact statements of actions usually unaccompanied by any cost estimate assigned to these efforts. This report makes clear that the potential risk from cyber attack is significant. Investors would not tolerate minimal to no discussion of various natural, legal, or regulatory risk. There is no reason for investors to tolerate a lack of disclosure in this critical area.

GUAM REVENUE ISSUERS UNDER PRESSURE

In the aftermath of Puerto Rico’s ongoing fiscal crisis, investors seeking triple tax exempt debt may have looked to Guam. After some steps were taken to improve the central government’s fiscal position, the credit became somewhat more attractive for investment. Now it appears that this may no longer be a viable strategy. The island’s GO is on negative outlook and now the revenue issuers on Guam are under pressure as well.

Moody’s announced this week that the Baa2 rating on the A.B. Won Guam International Airport Authority’s senior General Revenue Bonds was affirmed  but that it had changed the rating outlook to negative from stable. The change in rating outlook to negative reflects Moody’s assessment of the linkage between Guam International Airport Authority and local economic conditions in Guam.  Moody’s is concerned that a deterioration of local economic conditions could put negative pressure on travel demand to and from the island, and would likely have an impact on enplanements and routes offered by airline carriers. In that regard, Delta Airlines has recently decided to no longer serve the Guam Airport and United Airlines also reduced some of its weekly Japan flights as result of lower demand from Japan. Japan is the major source of tourism to Guam.

Moody’s affirmed the Baa2 ratings on the Guam Power Authority (GPA)’s senior revenue bonds but also changed the outlook to negative from stable. According to Moody’s, GPA operates fairly independently from the government. It expects that the authority would not be able to disconnect itself from the local economic conditions or material financial stress at the government level. Until now, the government has remained current on paying its bills and there has been no pressure to receive transfers 2017 electric revenue. A deterioration of government finances or local economic conditions could put pressure on outstanding receivables and customers’ ability to pay their bills. In addition, the Public Utility Commission’s willingness to support rate increases could weaken during time of economic stress.

WATER IN THE WEST – CALIFORNIA DRINKING WATER TAX

A new study from the University of California at Davis identifies those San Joaquin Valley residents without access to drinking water. The report names some 300 areas, many in unconsolidated communities which do not have their own water systems supplied by any of the major California water distributors. In many cases, these connections are not the result of a lack of proximity to these suppliers. Rather they are the product of a lack of funding to finance such projects.

Many of these communities rely on water supplies which are vulnerable to runoff which allows any number of dangerous chemicals to taint the supplies for these systems.  This is especially common in unincorporated communities categorized as disadvantaged, which are also overwhelmingly Hispanic. Some of the systems have treatment facilities attached to them but the economics of operating these plants has led to their shutdown or abandonment. The result is the presence of substances like arsenic and nitrate. Some 300 public water systems in California are believed to be contaminated.

Now legislation has been introduced in the California legislature to provide funding for the creation of a fund to finance the cost of connecting these individual systems to larger systems which can treat the water over a larger base to reduce the per user cost of cleaning the drinking water. Senate Bill 623 would establish a fund to help those communities pay for water treatment projects.

It would seem to be an idea which would lend itself to broad based support and there is such support in the legislature. But enactment is not a sure thing due to the source of funding for the proposed fund. That source is a proposed tax on the bills of other water users. The bill would impose, until July 1, 2020, a safe and affordable drinking water fee in specified amounts on each customer of a public water system in the State. The bill, until January 1, 2033, would require a every person who manufactures or distributes fertilizing materials to be licensed by the Secretary of Food and Agriculture and to pay to the secretary a fertilizer safe drinking water fee of $0.005 per dollar of sale for all sales of fertilizing materials. The bill, on and after January 1, 2033, would reduce the fee to $0.002 per dollar of sale.

A number of large municipal water systems have registered opposition. Many systems in California have used water charges to help further water conservation during times of drought. These increased rates have led to pressure on local water boards to minimize rate increases whenever possible. In addition, the bill would impose a specific fee on milk producers. These producers are a powerful lobby in the nation’s largest milk producing state. This political pressure serves to generate opposition to the proposed tax.

The Association of California Water Agencies has come out against the bill in its current form.  ACWA and more than 135 public water agencies are advancing what they present as a more appropriate alternative – a package of existing and proposed funding sources that do not include a tax on drinking water. This package includes ongoing federal safe drinking water funds, state general obligation bonds and an augmentation from the state general fund, in addition to agricultural assessments proposed in the bill.

Arguably, any increase for an individual water system which is not related to the coverage of its own operating costs and debt service could be considered credit negative.

DOJ SIDES WITH STATES IN INTERNET TAX CASE

In 1992, the US Supreme Court ruled in Quill v. North Dakota, that states could not tax mail-order products delivered from other states through common carrier or the U.S. Postal Service. Internet retailers such as Amazon have used the ruling to avoid collecting state sales taxes. Because Congress has refused to pass legislation allowing states to collect sales taxes from internet retailers, many U.S. jurisdictions have been unable to collect sales taxes they are owed from online sales.

South Dakota vs. Wayfair Inc., which will be orally argued before the Supreme Court in April, was filed after that state passed a law seeking to collect the sales tax from online retailers. The U.S. Department of Justice (DOJ) has filed a brief in the U.S. Supreme Court supporting state efforts to collect internet sales taxes. The DOJ argues that “In light of internet retailers’ pervasive and continuous virtual presence in the states where their websites are accessible, the states have ample authority to require those retailers to collect state sales taxes owed by their customers. Quill Corp. v. North Dakota should not be read to bar that result, both because the Quill Court did not and could not anticipate the development of modern e-commerce, and because Quill’s analysis was deeply flawed.”

Quill allows states to collect sales taxes only from businesses that have a physical presence in their jurisdictions. DOJ argues further that  “the nature of an internet retailer’s presence in the states where its website is accessible is different in kind from any type of ‘presence’ that the court could have anticipated…. And given the proliferation of such retailers, imposition of a physical-presence requirement would substantially impede state tax collection and…distort retailers’ choices of appropriate business models.

DOJ now joins 35 states which have filed friend of the court briefs in the case supporting South Dakota’s effort.

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