1. Public Finance 201 for Illinois School Districts Illinois Association of School Business Officials Annual Meeting—St. Charles, Illinois May 17, 2006 2045379 Sean McCarthy, A.G. Edwards & Co. Nona Myers, Illinois Finance Authority Tim Stratton, Chapman and Cutler LLP

2. 2 Presentation Overview and Panel Members Financing Options: –Methods of Issuing Tax- Exempt Debt Focus on Financing Issues: –Capital Appreciation Bonds –Premium Bonds –Working Capital Borrowings Legal Issues: –Rebate –Disclosure Sean McCarthy, A.G. Edwards Timothy Stratton, Chapman and Cutler Nona Myers, Illinois Finance Authority

3. 3 Methods of Issuing Tax-Exempt Debt Private Placement Public Bond Issues –Competitive Sale –Negotiated Sale Conduit Issuers

4. 4 Methods of Issuing Tax-Exempt Debt (cont.) Private Placement Bonds sold directly to a limited number of investors – often a bank Use of a financial services firm to serve as “placement agent” to negotiate terms Costs are usually lower but interest rates can be higher Often efficient for small (less than $1 million) bond issues

5. 5 Methods of Issuing Tax-Exempt Debt (cont.) Competitive Sale - Mechanics A financial advisor is used to help an issuer through the bond issuance process A fixed date and time is selected (2+ weeks in advance) to take sealed bids from underwriters who wish to purchase bonds Bonds are awarded to the underwriter(s) offering the lowest interest cost

6. 6 Methods of Issuing Tax-Exempt Debt (cont.) Competitive Sale Advantages –Public perception –Easily understood –Lowest interest rate of bids received –The entity setting the interest rates (bond purchaser) is different from the entity advising the issuer on the sale process (FA) Disadvantages –Issuers have little flexibility to change sale date or the structure of bonds once sale date is published –No control by issuer regarding who purchases bonds

7. 7 Methods of Issuing Tax-Exempt Debt (cont.) Negotiated Sale - Mechanics Underwriter is chosen early in the process and helps the issuer throughout the bond sale Issuer works directly with an underwriter negotiating the selling price of the bonds, which are then sold to investors

8. 8 Methods of Issuing Tax-Exempt Debt (cont.) Negotiated Sale Advantages –Flexibility to change sale date or issue structure in response to market changes –Ability to presell bonds Disadvantages –Interest rate levels need to be compared to other bond issues to guarantee competitive cost of capital –Not perceived as “competitive” to public

9. 9 Methods of Issuing Tax-Exempt Debt (cont.) Conduit Issuers Bonds are issued through a third party Potentially provides lower interest rates than would be available issuing alone Provides economies of scale, especially in pools Potential double tax-exemption

10. 10 What are Capital Appreciation Bonds? Capital Appreciation Bonds (CABs) are zero-coupon bonds that pay all interest at maturity and purchased at a discount, similar to a Treasury Bill. CABs are used to defer both principal and interest payments. CABs have interest rates that are.40%-.50% higher than current interest bonds.

11. 11 Why do schools use CABs? CABs can allow an issuer to extend debt under a Debt Service Extension Base. The Tax Limitation Law allows school districts to issue bonds for life safety and working cash fund purposes as long as the payment for these bonds does not exceed the bond and interest levy from 1994 (or whenever the Tax Cap was approved for that issuer). This levy is referred to as the Debt Service Extension Base. Non-referendum bond debt service may not exceed this amount.

12. 12 Premium Bonds Premium bonds are sold for a price that is higher than the face value (par). Investors pay a premium in return for a higher coupon rate on the interest paid on the bond. At maturity, the investor receives the face value or par amount of the bond. For example, if a bond has a face value of $100 and a yield of 4%, an investor that pays $120 (a $20 premium) for the bond will receive a higher interest rate (say 6%) in return for their extra $20. The interest on the $100 face amount is calculated at 6% and when the bond matures, the investor receives the $100 face value.

13. 13 Premium Bonds In this relatively low interest rate environment, investors have a high demand for premium bonds. Regardless of the method of sale or the amount being financed, the market demand for premium bonds is evident in the coupon structure of almost every bond bought or sold in the market today. School district issuers typically and traditionally use bond premium to pay for the costs of issuing bonds and capitalized interest, if any, in order to preserve the total amount of proceeds for projects.

14. 14 Premium Bonds (cont.) Example 1: District issues $610,000 of life safety bonds; costs of issuing bonds not included in life safety approval-only life safety projects; District sells premium bonds to cover costs of issuing bonds. ParCouponYieldPricePremium 2006 330,0004.65%3.33%100.983,218 2007 145,0004.65%3.37%102.163,135 2008 135,0004.50%3.40%102.873,872 610,00010,224

15. 15 Premium Bonds (cont.) Sources Par Amount610,000 Premium10,224 Total620,224 Use Life Safety Projects610,000 Costs of Issuance10,224 Total620,224

16. 16 Premium Bonds (cont.) Bond premium, unlike bond principal, does not count against the statutory debt limit. The maximum coupon (interest rate) allowed by statute is 9%. The difference between market yields (say 4%) and max rate of 9% allows large amounts of premium to be generated on a bond issue.

17. 17 Borrowings for Working Capital  Tax Anticipation Warrants  Working Capital Working Cash Fund Bonds General Rule: Proceeds of an issue may only be allocated to working capital expenditures as of any date to the extent those working capital expenditures exceed available amount as of that date.

18. 18 “Available Amounts” — any amount that is available to an issuer for working capital expenditure purposes of the type financed by an issue. —Includes: 1)Cash 2)Investments 3)Other amounts that may be used without legislative or judicial action or without a legislative, judicial or contractual requirement that those amounts be reimbursed. Preparation of cash flow estimates. Borrowings for Working Capital (cont.)

19. 19 Tax and Securities Law Issues with Respect to School Borrowings

20. 20 Arbitrage Basic rule: Interest on a bond is not tax-exempt if it is an “arbitrage bond.” “Arbitrage bond” - Any bond issued in which any portion of the proceeds are reasonably expected (at the time of issuance) to be used directly or indirectly to: 1) Acquire higher yielding investments, or 2) Replace funds that were used directly or indirectly to acquire higher yielding investments.

21. 21 What is Yield? “Yield” on a fixed rate issue - the discount rate which when used in computing the present value as of the issue date of all payments of principal and interest and fees for qualified guarantees on the issue (bond insurance) produces an amount equal to the issue price. “Yield” on investments - computed on the same basis as bonds, but using purchase price of the investments.

22. 22 3-Year Temporary Period from Rebate - Capital Projects Only Reasonable Expectations Sale and investment proceeds 3 Tests: — Expenditure Test - 85% within 3 years. — Time Test - 5% within 6 months — Due Diligence Test Certification Required No protection for intentional acts or bad faith

23. 23 Reimbursement Proceeds are not treated as allocated to an expenditure (and are thus unspent) unless: — Within 60 days there’s an expression of official intent to reimburse; and — Reimbursement is made not later than 18 months after the later of: 1)The date of the expenditure; or 2)The date the project was placed in service or abandoned, but not more than 3 years after the date of the expenditure.

24. 24 Rebate Rebate - a bond is an arbitrage bond unless the rebate requirements are satisfied Amount: the sum of (i) the excess of the amount earned on all nonpurpose investments over the amount that would have been earned on those investments if those investments had been invested at a yield equal to the yield on the issue, plus (ii) any income attributable to that excess. When: — At least once every 5 years — At least 90% of the excess earnings — Within 60 days of the final retirement of the bonds

25. 25 Exceptions to Rebate Issue Size Exception - $5,000,000 Limit - $15,000,000 Limit Expenditure Exceptions - 6 months - 18 months 1) 6 months - 15% 2) 12 months - 60% 3) 18 months - 100% (5% reasonable retainage) - 24 months for construction projects 1) 6 months - 10% 2) 12 months - 45% 3) 18 months - 75% 4) 24 months - 100% (5% reasonable retainage)

26. 26 CONTINUING DISCLOSURE SEC Rule 15c2-12

27. 27 To Whom? Nationally Recognized Municipal Securities Information Repositories (NRMSIRs) www.sec.gov/info/municipal/nrmsir.htm

28. 28 Issues Under $1,000,000 No Continuing Disclosure Required

29. 29 Issues from $1,000,000 to $10,000,000 Limited Continuing Disclosure Financial Information upon request Material Events

30. 30 Material Events... What are they? Principal and interest payment delinquencies Non-payment related defaults Unscheduled draws on debt service reserves reflecting financial difficulties Unscheduled draws on credit enhancements reflecting financial difficulties Substitution of credit liquidity providers, or their failure to perform Adverse tax opinions or events affecting the tax-exempt status of the security

31. 31 Material Events... What are they? (cont.) Modifications to the rights of security holders Bond calls Defeasances Release, substitution or sale of property security repayment of the securities Rating changes

32. 32 Issues of $10,000,000 or more Full Continuing Disclosure Annual Financial Information –210 days after end of fiscal year Audited Financial Statements –30 days after availability Material Events –Upon occurrence

33. 33 Consequences of Failure to Comply

34. 34 The IRS and the SEC Are Actively Demanding -- Better analysis and disclosure with respect to federal tax matters, from — Municipal Issuers and their counsel — Bond Counsel — Underwriters and their counsel — Financial Advisors — Credit Enhancers

35. 35 SEC is Very Clear in Enforcement Actions: see www.sec.gov The Issuer, its officers and governing body, have the primary disclosure obligation

36. 36 Disclose All “Material Facts” The information any investor requires for an informed investment decision. Creditworthiness — Current financial statement information — Adequacy of revenue source — Use of proceeds — Status of construction risks (on-budget?) Federal Tax Facts & Conclusions — Underlying factual basis for overall legal conclusion as to tax exemption of interest paid on bonds

37. 37 IRS & Sec Enforcement Actions in Neshannock School District $9.6 million of 3 year tax exempt notes for school construction; proceeds invested for entire 3 year period at $225,000 arbitrage profit; proceeds never used for stated purpose. IRS bond audit: Issuer pays IRS $150,000, and costs of defense SEC cease and desist action: — Issuer settles and pays SEC $29,000, and cost of defense — Banker accepts SEC order and leaves — Bond Counsel goes to Admin. Trial

38. 38 IRS & Sec Enforcement Actions in Neshannock School District (cont.) Issuer’s Reasonable Expectations at issuance are viewed with HINDSIGHT IN ENFORCEMENT