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Home Rule Units – Sales Tax Securitization Using Special Purpose Entity Home Rule Units – Sales Tax Securitization Using Special Purpose Entity

Home Rule Units – Sales Tax Securitization Using Special Purpose Entity

The Illinois General Assembly approved a new local borrowing program during summer 2017 permitting home rule municipalities (“HRMs”) to bypass weak general obligation ratings by securitizing their state-supplied sales tax, or other state revenue, utilizing a bankruptcy-remote securitization structure. The legislation is designed to allow Illinois home rule issuers to access capital using an alternative borrowing structure that achieves higher credit ratings than would otherwise be available under a general obligation borrowing. This program is particularly valuable to lower-rated home rule units. Similar legislation has previously been enacted and utilized in New York City, NY; Philadelphia, Pa. and Washington, D.C.

Public Act 100-0023, effective July 6, 2017, added Division 13 to Article 8 of the Illinois Municipal Code, as amended (65 ILCS 5/8-13-5 et seq.) (“Authorizing Statute”) and authorizes any HRM to enter into agreements (each, an “Assignment Agreement”) to assign, sell, transfer or otherwise convey all or any part of any revenues or taxes it receives (“Transferred Receipts”) from the State Comptroller, the State Treasurer or the Illinois Department of Revenue (the “Department of Revenue” and collectively, the “State Agencies”) to a corporation, trust or other independent, limited-purpose special purpose entity (“SPE”) that has been established for the limited purpose of issuing obligations (“Obligations”) for the benefit of such HRM. The City of Chicago and the Village of Bridgeview have already taken advantage of the Authorizing Statute. 

Fitch Ratings

As Illinois home rule units consider utilizing the structure, the following issues need to be considered:
  1. Creation of SPE
  2. Governance of SPE
  3. Conveyance of Transferred Receipts
  4. Borrowing Limits
  5. Rating Agency/Bond Insurer/ Bond Market
  6. Covenants
  7. Prior Debt and Future Debt
  8. Bankruptcy Provisions and Opinions
  9. Security Provisions
Illinois sales tax revenues will likely be the most common Transferred Receipts utilized.

Sales Tax Securitization Flow of Funds
Sales Tax Flow of Funds

Creation of Entity
An SPE is a separate legal structure commonly used by commercial enterprises to provide liquidity and/or obtain favorable external funding. Securities issued by the entity in such transactions are backed by isolated assets as collateral or the guarantee of specified revenue streams, as “credit enhancements,” that reduce risk to the purchasers and, therefore, further reduce the cost of funding. 

The HRM, pursuant to an act of its governing board, may create an SPE. The SPE would be created pursuant to the General Not For Profit Corporation Act of 1986 (805 ILCS 105/101) and would be organized in the manner that it can be considered a governmental unit and an instrumentality of the HRM, for bankruptcy purposes, rather than treated as a profit corporation.

By creating the SPE with specific provisions that do not infringe on the Obligations, the SPE can qualify as an issuer of tax-exempt bonds on behalf of the HRM. An issuer of tax-exempt bonds must be a state or political subdivision or an entity that issues on behalf of a state or political subdivision. To be a political subdivision, the entity must be a governmental entity that possesses one of the three sovereign powers (eminent domain, taxation and police). As the SPE is unlikely to possess such a power, in order to be an acceptable issuer, bond counsel must conclude the SPE complies with Internal Revenue Service Rev. Proc. 63-20 or be a constituted authority that qualifies as an “on behalf of” issuer under the Authorizing Statute.

Governance Issues of SPE
The new entity will need to have members and governing bylaws. The HRM will decide who is to serve on the governing board for the SPE to ensure sufficient control and assure the SPE is acting “on behalf of” the HRM, but with the independence needed to achieve opinions of bankruptcy remoteness from the HRM in order to avoid any adverse rating concerns. Some, but not all, of the board members of the SPE may be affiliated with the HRM. This measure of independence may be achieved by requiring the SPE to have, at all times, at least one director not affiliated with the HRM (“Independent Director”). Further, its governance documents should not permit any actions to admit insolvency/commence an insolvency proceeding or otherwise engage in specified actions outside of the ordinary course absent an affirmative vote of the Independent Director.

Conveyance of Transferred Receipts
Pursuant to an Assignment Agreement, on the closing date the HRM irrevocably sells and conveys all right, title and interest of the HRM in and to the Transferred Receipts to the SPE. The sale and conveyance is absolute, unconditional without recourse subject to certain continuing obligations in the Assignment Agreement and is established as of the closing date and for a specified period. As consideration for such sale and conveyance of the Transferred Receipts by the HRM to the SPE, on the closing date, the HRM receives a residual interest in the Transferred Receipts and the proceeds (net of the costs of issuance) of the Obligations in accordance with, and subject to, the terms of an Indenture and the Authorizing Statute.

In accordance with the Authorizing Statue, the sale and conveyance and other transfer of the right to receive the Transferred Receipts should be structured to constitute a “true sale” and absolute conveyance of all right, title and interest therein and not as a pledge or other security interest for any borrowing, valid, binding and enforceable in accordance with the terms of the Assignment Agreement and the Indenture.
During the period for which the Transferred Receipts are payable to the SPE and pledged under the Indenture, the right of the SPE to receive the Transferred Receipts will be superior and prior to the right and claim of the HRM.

Borrowing Limit
There is no legal limit to the amount of debt the SPE may have outstanding at any given time.

Rating Agency/Bond Insurer/Bond Market Determinations
General obligation bonds (“GOs”) are generally looked upon more favorably by rating agencies, because the bond issuer pledges its full faith and credit to the payment of the GOs. Transferred Receipts, as a source of payment pledged to bonds, generally are rated lower than GOs. However, by creating an SPE, and thereby segregating from the HRM the pledged revenue source (i.e., the Transferred Receipts) for the Obligations, higher bond ratings are expected to continue to be achieved.

General Covenants
  1. In the Authorizing Statute, the state pledges to and agrees that the state will not limit or alter the rights and powers vested in the State Agency by the Authorizing Statute with respect to any Transferred Receipts that have been conveyed by the HRM to the SPE under the Assignment Agreement so as to impair the terms of any contract in connection with the issuance of Obligations until all requirements with respect to the deposit by the State Agency for the benefit of the SPE have been fully met and discharged. In addition, the State Agency pledges to and agrees with the HRM and the SPE that the state will not limit or alter the basis on which the HRM’s share or percentage of Transferred Receipts is derived, or the use of such funds, so as to impair the terms of any such contract.
  2. The HRM typically will irrevocably direct the Director of the State Agency to transfer all Transferred Receipts directly to the trustee for the Obligations as the assignee of the SPE.
  3. The HRM will covenant to make reasonable efforts to pursue action legally available to it to ensure collection of Transferred Receipts in adequate amounts to pay debt service on the Obligations.
  4. The HRM must cooperate with the SPE to the fullest extent permitted by law, including the Authorizing Statute, to assure receipt by the SPE of all of the Transferred Receipts when and as due in accordance with the Assignment Agreement.
  5. Pursuant to 65 ILCS 5/8-10, the SPE is authorized to direct the applicable HRM to deposit the Transferred Receipts into an irrevocable deposit account, separate and apart from other accounts of the SPE. The Assignment Agreement may “provide for the periodic reconveyance to the HRM of amounts of transferred receipts remaining after the payment of the” debt service on the Obligations.
Existing Sales Tax Pledge and Parity Bond Provisions
The HRM must recognize and address existing bond documents and parity bonds. If the HRM already has bonds or other obligations outstanding for which the HRM has pledged Transferred Receipts, then the pledge of the Transferred Receipts to the SPE must recognize that existing pledge or lien, presumably with the subordination of the new pledge or refinancing the prior obligations so the new Obligations have or share a first-priority lien.

Additional bond provisions may be added to the Indenture and can be used to issue future bonds, depending on the market’s satisfaction of the quality and amount of the Transferred Receipts.

Security Provisions
Pursuant to 65 ILCS 5/8-13-11 of the Municipal Code, “[T]he obligation issued by the [SPE] shall be secured by a statutory lien on the [T]ransferred [R]eceipts received, or entitled to be received, by the [SPE] that are designated as pledged for the [O]bligations.” The Obligations will then have a first priority lien, unless the authorizing documents otherwise provide.

The Authorizing Statute provides that Obligations issued by the SPE shall be secured by a statutory lien (with the meaning given to such term in Section 101(53) of Title 11 of the Bankruptcy Code) on the Transferred Receipts received or entitled to be received by the SPE. The statutory lien shall automatically attach, from the time such Obligations are issued, without further action or authorization by the SPE or any other entity (including the HRM), person, governmental authority or officer. The statutory lien shall be valid and binding from the time such Obligations are executed and delivered, and the statutory lien shall automatically be effective, binding and enforceable against the SPE, the HRM, the State Agency and their agents, successors, transferees and creditors.

Although Illinois does not authorize bankruptcy of governmental units such as the HRM, the HRM and the SPE should take steps to minimize the risk that, in the event the HRM were to become the debtor in a bankruptcy case, a court would order the assets and liabilities of the HRM be substantively consolidated with those of the SPE. The SPE is a separate, special purpose not-for-profit corporation; the organizational documents of which should provide that it shall not commence a voluntary bankruptcy case without the unanimous affirmative vote of all of its directors.

Certain bankruptcy opinions of counsel are expected to be provided. Counsel should render an opinion to the SPE in which the HRM is a debtor, that a court, exercising reasonable judgment after full consideration of all relevant factors, would hold (i) the money paid or payable (including after the petition date) by the state to the HRM as assigned to the SPE pursuant to the Assignment Agreement, and the Authorizing Statute is not property of the HRM and not “property of the estate” of the HRM and (ii) the rights of the SPE to such money are not subject to the operation of Section 362(a) (as incorporated in Chapter 9 by the operation of Section 901(a)) or Section 922(a) of the Bankruptcy Code in a Chapter 9 case of the HRM.

An opinion is also typically delivered that provides that the court would not order the substantive consolidation of the assets and liabilities of the SPE and those of the HRM.

The Authorizing Statute enables the HRM to utilize bankruptcy-remote securitization to reduce borrowing costs. Illinois home rule municipalities should consult with appropriate bond counsel, legal counsel and finance professionals to consider the issues involved and benefits to be received.

Ice Miller’s Illinois Municipal Finance Practice
Ice Miller LLP has served as bond counsel, disclosure counsel and special counsel to local governments since its founding in 1910.

Our attorneys have served as bond counsel to the City of Chicago, and the state of Illinois as well as numerous counties, villages, cities, school districts, park districts, forest preserve districts and authorities located in Illinois. Each year, in our Illinois, Indiana and Ohio offices, we approve 330 to 400 long-term municipal financings with a total principal of up to $6.8 billion.
According to recent Thomson Reuters Annual Municipal Reports, our Illinois bond lawyers ranked with respect to long-term Illinois municipal bond issues:
  • #1 in number of issues as underwriter’s counsel (2016, 2017)
  • #2 in number of issues as bond counsel (2016, 2017)
  • #2 in number of  issues as disclosure counsel (2016, 2017)
  • #3 (2016) and #4 (2017) in par amount as underwriter’s counsel
  • #5 in par amount as bond counsel (2016)

For more information, please contact Robert Schillerstrom, James Snyder, Steven Washington, Jeff Hokanson, Shelly Scinto or another member of our Municipal Finance Group.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.

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