Standard & Poor's Ratings Services said it lowered its ratings to CCC-plus from BB on Hercules Public Financing Authority, Calif.'s series 2010 (electric system project) revenue and revenue refunding bonds, series 2003B lease revenue bonds, and series 2009 taxable lease revenue bonds (Bio-Rad Project), issued for the city of Hercules.

The outlook on all bonds is stable.

"The downgrade reflects our view of the city's future willingness and stated inability to pay on general fund-supported debt from its general fund after its statements in a September 2012 material event notice," said Standard & Poor's credit analyst Sussan Corson. Although the series 2010 bonds' debt service payments are backed by a city covenant to advance available funds in the general fund as well as net electric system revenue, Hercules states in the material event notice that "The city does not anticipate there will be any available funds to make such advances in the foreseeable future and does not expect to make any such advances."

City officials confirm that, for the next several years, they intend to continue to transfer annually from a current $4.5 million available balance from unspent bond proceeds in the series 2010 bond acquisition and construction fund into the electric system revenue fund to support about $900,000 of related annual debt service. However, they do not expect the general fund will advance any future amounts to support debt service once the bond acquisition and construction fund is depleted.

The city also intends to fund $800,000 of capital expenditures this fiscal year from the bond acquisition and construction fund. Assuming no other source to pay on the electric system revenue and revenue refunding bonds than the bond debt service reserve and identified bond proceeds in the bond acquisition and construction fund, the city could default on these bonds in four to five years.

As part of the series 2010 issuance, the city had entered into a cooperation agreement with the Hercules Public Financing Authority. Pursuant to the agreement, Hercules' covenant to make the necessary payment to the authority no later than five days before the bond payment date is an absolute obligation, not subject to deduction or offset of any kind. The cooperation agreement requires the city to amend the general fund budget, if necessary, to make the appropriations to cover the lease payments. Since the electric system has failed to generate positive net income or support its own debt service, the rating reflects S&P's view of the city's general fund pledge.

The stable outlook reflects the city's current ability to meet its debt service obligations, despite the expectation that, absent favorable financial or economic conditions, Hercules would not meet certain general-fund supported debt obligations in the long term, as reflected in recent city statements.

Hercules continues to maintain a structural imbalance in its general fund with a weak financial and liquidity position, despite the June 2012 passage of a new sales tax measure by voters.

In addition, the lack of a fiscal 2011 audit, the transition in city management and council, and the previous pooled accounting between Hercules and its redevelopment agency (RDA) have clouded the city's true financial position. Should city officials declare either their intention to file for bankruptcy or their intention of nonpayment on general fund-supported debt service in the next year, the rating could be lowered further. Should Hercules resolve all claims against it and its RDA, and should it redeem or pay on the electric system revenue bonds in full while closing the structural general fund budget gap to regain long-term fiscal stability, the rating could be raised.

Hercules (population 24,555) is in Contra Costa County, 23 miles northeast of San Francisco on the northeastern shore of San Francisco Bay.

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