CHICAGO — A Minnesota city that voted last month to cancel its lease and financial support for a struggling sports complex paid a steep price for its action, losing its investment-grade ratings even though the city contends it was simply exercising its legal rights.
Moody’s Investors Service and Standard & Poor’s quickly chopped Vadnais Heights’ formerly double-A bond ratings to junk after the city said it would sever its lease for the Vadnais Sports Center, which supports payments on the $27 million of lease-backed revenue bonds issued to build the complex.
The city provided $500,000 to fully cover an August debt service payment and will continue to make monthly lease payments through the end of the year. But the payments, which subsidize the complex’s shortfalls, will halt ahead of a Feb. 1 debt service payment.
With the sports center generating some revenue and $1.6 million held in reserves, a payment default can be staved off for a year or two but the project’s fate and the prospects for bond repayment over the long term remain clouded.
Under its master lease agreement, Vadnais Heights is able to decide annually whether to cancel the lease, but rating agencies quickly punished it for that choice. S&P late last month lowered the city’s general obligation rating to B with a stable outlook from A. The downgrade followed another in July. The city previously was rated AA.
Standard & Poor’s also lowered three of the four series of the lease revenue bonds for the complex to CC with a negative outlook, down from A-minus. They were once rated AA-minus.
Moody’s Investors Service last week knocked its rating on $1.8 million of the city’s $10.6 million of GOs down to Ba1 with a stable outlook from Aa2. The agency does not rate the lease bonds.
The city anticipated its action would take a toll on its ratings but the dive into junk-bond territory caught officials off guard based on their interpretation of the lease’s language. Still, they believe it was the right step.
“We are very disappointed in the performance of the project and the issue is a city of our size cannot continue to fund shortfalls of this size,” said Marc Johannsen, mayor of the suburb about seven miles north of St. Paul that is home to 12,000 residents. “We never anticipated the kind of shortfalls that have occurred. The deal that was promised to us was not delivered as promised.”
The city has no borrowing plans on the horizon and should be able to manage to fund capital with funds on hand for the time being, the mayor added.
Trustee U.S. Bank NA will hold a conference call for bondholders on Sept. 27 at 1 P.M. Central Time to “discuss the events of default and the status of the project,” according to bondholder notices.
The complex transaction in April 2010 differed from most lease-backed deals in the state, according to a bond lawyer familiar with state lease financing laws. The city agreed in 2010 to a conduit-like financing in which the Vadnais Heights Economic Development Authority issued $25 million of taxable and tax-exempt bonds on behalf of a nonprofit, CFP Vadnais Heights LLC.
The proceeds were used to acquire 10 acres of land and build the Vadnais Sports Center, a 100,000-square-foot domed multi-sport facility with a two-rink ice arena. The city serves as the tenant leasing the facility for a rental payment equal to the its annual operating budget, which includes debt-service costs. The project also included three commercial lots that were eventually to be sold.
Johannsen, who served on the City Council at the time, said the company and developer crafted the deal and brought it to the city, and various analyses projected the facility would generate enough revenues to repay the bonds.
Dougherty & Co. served as underwriter of the deal with Briggs and Morgan as bond counsel. The city is currently working with Kathy Aho of Springsted Inc. for advice on the project and Kennedy & Graven attorney Stephen Bubul is providing legal advice.
The bonds sold in four series with a final 2041 maturity. The $11.7 million of Series A recovery zone facility lease revenue bonds carried yields in the 5% range and have been trading around 15 cents on the dollar. The $11.3 million of Series B lease revenue bonds yielded in the 2.8% to 4.2% range and have traded at a range of between 37 cents and 57 cents on the dollar, depending on maturities.
The sale also included a taxable Series C for $1.8 million and an unrated $2 million Series D of taxable subordinate lease-revenue notes.
Loan payments by the company to the Economic Development Authority secure the bonds. The trustee also holds a first-mortgage lien on the project and has a claim to the three commercial lots. Annual debt service next year totals about $1.6 million.
Bondholders could eventually foreclose on the facility, try to lease it, or pursue litigation challenging the city’s decision, lawyers said.
Under the master lease agreement, the city holds the right to annually decide 120 days before the end of the year whether to appropriate funds in the next year to honor its obligations. If it opts not to, the lease is terminated at the end of the year.
The struggling facility was supposed to generate $2.4 million in its first year of operations in 2011 but it made just $300,000. With the expectation that project revenues could fall at least $1 million short of what’s needed annually over at least the next two years, the city voted to end its relationship with the facility late last month.
Vadnais Heights operates on just a $4.6 million annual budget.
Though a payment default has not occurred, events of default have been triggered by the company’s past failure to directly deposit revenues in a timely fashion with the trustee and the city’s failure to make some monthly payments earlier this year. The city later made up the shortfall to fully cover the August 1 debt service payment on the A, B and C series. The city’s decision to halt payments next year also triggers a default event.
Though the city is now in the ranks of junk-bond issuers, its overall fiscal profile remains strong with a general fund balance equal to 64% of expenditures.
“We find that this failure to appropriate funds indicates a severe lack of willingness to pay debt service, and thus reduced overall credit quality,” Standard & Poor’s said. Analysts said city officials originally indicated to the agency that it would annually appropriate funds if necessary. Without improved fiscal performance, the reserves could be drained in 2014 or 2015, the agency warned.
The city defends its action as the most affordable option, saying otherwise a massive tax increase or service cuts would be needed to make up the project’s shortfalls and it contends the action was legally permissible.
“The bond rating agencies shouldn’t punish the city for exercising its rights,” said Johannsen, who is also an attorney.
Moody’s said while the city’s cancellation may be permitted under the master lease, the city is failing to honor an obligation that was expected when the lease bonds were offered to investors.
“While we recognize that the city’s right to terminate is clearly stated within the governing documents, the city’s appropriation pledge was critical to the security of the EDA’s lease revenue bonds. The termination and stated unwillingness to appropriate for the life of the bonds represents a significant lack of willingness to pay on the part of the city,” analysts wrote.
Moody’s suggested it could take years of honoring its other debt commitments to win an upgrade.
Under Minnesota statutes, lease debt is not considered a direct obligation of a municipality because of the language typically included that allows a government to sever the lease, according to a public finance attorney. It’s a popular form of financing for local governments in Minnesota as it allows them to bypass voter approval. The attorney said the Vadnais structure was unique in its conduit-like structure with a nonprofit serving as the borrower instead of the municipality.
Several market participants said the Vadnais deal — like other struggling or failed economic development or entertainment projects supported by municipalities — underscores the importance of a credit review that looks at direct and indirect debt and assesses the ability of a government to support a project should it fail to meet expectations.
“It also brings us back to the issue of essentiality” and whether a government is likely to stand behind the project, said Richard Ciccarone, chief research officer at McDonnell Investment Management.
The City Council recently fired the complex manager, Sports Facility Development and Management Group, after an audit last year raised questions over its management. City officials are weighing approval of a more detailed forensic audit in hopes of gleaning how the center fell so far short of expectations.
Vadnais’ struggles have not dampened the enthusiasm among other cities in the state with similar projects in the works, according to local press reports. West St. Paul and Savage have sports arenas opening this fall, but they believe their operating goals are more realistic to support projects that carry far lower price tags of between $4 million and $7 million.
The same management group fired by Vadnais Heights will run the new facilities.