Rating agency choice scrutinized in audit of a California school district

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A recent audit by a California agency raised questions about a San Diego-area school district's decision to choose a rating agency with criteria likely to result in a higher rating for a general obligation bond sale.

The full Fiscal Crisis Management Team audit released June 22 reported “significant evidence” of malfeasance by current and former employees of Sweetwater Union High School District. It also casts some bond sales strategies in a critical light.

The audit questioned the Sweetwater Union High School District's decision to seek a sole rating from Fitch Ratings.

FCMAT said Sweetwater UHSD misled rating agencies, bond insurers and investors by failing to disclose the school district’s financial situation.

Sweetwater Superintendent Karen Janney and the district finance department failed to live up to their fiduciary duties, intentionally misrepresenting the district’s finances and failing to disclose information to the school board and to bond market participants, according to the audit.

Janney was asked to step down as superintendent at the June 24 school board meeting.

Board President Frank Tarantino, the only board member opposed to asking Janney to step down, also subsequently resigned.

The board released a statement saying that Janney’s removal was not a disciplinary action, but to support and ensure the efficient investigation of the concerns raised in the audit, according to the San Diego Union Tribune. The board said the district will cooperate with state county and federal authorities investigating the district.

Moises Aguirre, the district’s facilities and operations manager, who was named to replace Janney on an interim basis, didn't immediately respond to a request for comment.

FCMAT began the audit 18 months ago.

The audit, which covers the district's financial activities from June 2016 to June 2018, contends that during the 2017-18 fiscal year, the district “adopted a new approach to credit ratings for the general obligation bonds sold in April of that year.”

The report called the approach a significant departure from industry standard, past district practice, the recommendation of its bond underwriter, and previous board policy.

The most significant difference from past practices cited by the report appears to be that the district only sought a rating from Fitch Ratings, leaving out Moody’s Investors Service and S&P Global Ratings, and it failed to acquire bond insurance in the sale of the 2018C bonds that received the most scrutiny from FCMAT.

Only 5.9% of the par volume of municipal bonds issued in 2018 carried insurance.

The audit makes reference to a "special program" it says that Fitch gives bonds it considers to be “special revenues.”

Fitch changed how it rates many California school general obligation bonds in 2015, emphasizing the special tax backing for such GOs, which are not repaid through district's general budgets. That led to a number of AAA ratings.

At the Sweetwater district’s Feb. 12, 2018 board meeting, the CFO and the financial advisor recommended to the governing board that for the Series 2018C bonds, a rating only be requested from Fitch saying its approach makes AAA ratings more likely for California school district GO bonds.

“What Fitch does, if we pay a little bit of an extra fee for some attorney fees, is they will say we’ll only look at the district’s assessed value and the underlying economics and not focus on the district’s or the state’s general funds. And that was one of the reasons why you got a AAA with Fitch last time,” the FCMAT report quoted the district's financial advisor as saying.

“The approach appears to have prevented external disclosure of the district’s financial stress as early as February 2018,” the auditors wrote, in an apparent reference to Fitch's rating de-emphasis of the district's operating budget, which is not used to support GO bond payments.

However, FCMAT also notes that Fitch did in fact review the district's budget an operations at the same time and downgraded its issuer default rating.

Thought the FA was unnamed in the audit report, Fieldman Rolapp & Associates is listed as the FA in the offering documents for the bonds and Adam Bauer, the president and chief executive officer, said he would have been the one who gave the presentation.

“It’s not uncommon when the par amount is small to go with one rating,” Bauer said. “When the district did a request for proposals for underwriters, Citi also made the case that Fitch was the best choice, and the lowest cost would be to use one rating.”

The deal in question was for $28 million.

“Citi was one of the pioneers in getting Fitch to look at California school district ratings in a different light,” Bauer said.

Tanya Sierra, a spokeswoman in the San Diego District Attorney’s office, said it has received the audit and it is currently under review. She added that she had no further information to provide at this time in response to a question as to whether the DA’s office was jointly investigating the school district along with federal authorities such as the FBI or the Securities & Exchange Commission.

The SEC sent the district a letter in December 2018 asking it to preserve evidence and documents for an ongoing inquiry. In addition to documents related to district finances, the SEC letter asked about the school district’s credit ratings, independent auditors, audits and bond program.

The letter indicated the SEC would be seeking documents related to allegations of impropriety, fraud, mismanagement, and/or unlawful conduct in relation to Sweetwater’s finances or bond program.

The FCMAT audit alleged that district employees may have committed fraud and misappropriated funds, but auditors said in the report it is not their job “to assign guilt or declare whether fraud has occurred. That is up to the courts to decide.”

When San Diego County Superintendent Paul Gothold released the audit findings a week ago, he said the 79-page audit report would be forwarded to the San Diego County District Attorney’s office, the state controller and the state superintendent of schools.

Gothold could not be reached for comment.

Following a ruling by an bankruptcy court judge about Puerto Rico bonds last year, Fitch modified its practices, deciding that no California school district could achieve the AAA rating if the school district’s underlying rating based on operations were five notches below the highest rating, said Amy Laskey, a Fitch managing director.

One June 16, Fitch downgraded the district, cutting its issuer default rating to BBB from BBB-plus and its GO bonds to AA-minus from AAA. It assigned a negative outlook.

The downgrade on the district’s GO bonds “is partially a result of Fitch’s recent criteria change that allows a maximum five-notch rating distinction between the IDR and the pledged special revenue GOs,” Laskey said.

“The downgrade of the district’s IDR is due to increased operating risk brought on by the coronavirus pandemic, which also contributes to the downgrade of the GO bonds,” Fitch wrote.

The FCMAT audit noted that "despite the financial advisor’s communication to the board that Fitch would not look at the district’s general fund, Fitch did perform a credit review of its Issuer Default Rating," and downgraded the school district’s issuer default rating to A-plus from A at the same time that it rated the Series 2018C bonds AAA.

"FCMAT could not find evidence of disclosure of this credit downgrade to the governing board by the CFO and financial advisor," the audit report said.

“During FCMAT’s fieldwork, the current CFO was asked whether she thought it was unusual that the district pursued only the special revenue rating from Fitch,” according to the audit. “The current CFO agreed that this was unusual and thought perhaps there some savings to be had. The current CFO follow up with the district’s financial advisor, who confirmed to her that the purpose was to control the rating agency fees.”

Citi, who was the underwriter on the deal, had supported only seeking two ratings as opposed to three to save money, the FCMAT report said, but advised the district to seek ratings from both Fitch and Moody’s.

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