Scathing state audit of Sacramento schools doesn't stop bond deal

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The California state auditor's scathing review of the Sacramento City Unified School District's finances will not affect the closing on a $30.9 million general obligation bond sale, district officials said.

The audit was released Tuesday, two days before the scheduled closing of the deal priced by Stifel Financial Corp. Nov. 21.

“The audit is just another report that supports some of the other recommendations we have already seen from FCMAT [Fiscal Crisis and Management Assistance Team] and others,” Sacramento City Superintendent Jorge Aguilar said. “This is the fourth independent audit the district has gone through.”

The pending audit was included as a risk factor in the preliminary offering documents. On Tuesday, a one-page supplement was posted summarizing the information in State Auditor Elaine Howle’s 72-page report. The bond documents also linked to the audit.

The bonds carry an underlying rating of A2, with a negative outlook, from Moody's Investors Service. Build America Mutual insures them, bringing S&P Global Ratings' AA rating of the insurer.

“We have identified a number of options the district could take, including making changes to salaries and benefits for different groups of employees; however, if it is to avoid the negative effects of insolvency, Sacramento Unified must act quickly to develop and implement a plan,” California State Auditor Elaine Howle wrote in the audit’s opening letter.

The school district has failed to take sufficient action to control its costs in three main areas — teacher salaries, employee benefits, and special education, Howle said.

The district's struggles are no secret, playing out amid multiple audits and public acrimony between the teachers' union and the district administration, including a one-day strike in April.

All of the audits have pointed to the district’s unusually generous employee insurance benefits provided at no cost to employees. The district has proposed a plan in which employees would contribute to their healthcare costs, but Howle’s report contends that would only shave off $16 million when it needs to make $27 million in reductions by 2021.

The state auditor’s office also recommended the Legislature consider crafting a law that would give the county offices of education more control over a school district in distress.

“To help ensure that county superintendents can prevent school districts under their oversight from becoming insolvent, the Legislature should consider amending state law to require school district boards to obtain approval from their county superintendents before they consider significant spending actions,” the audit states.

The Sacramento County Office of Education warned the school district not to approve the salary increases in 2017 that have resulted in the structural deficit, said Margarita Fernandez, a spokeswoman for the state auditor. The 2017 labor concessions cost the school district $12 million to $13 million a year, which have depleted the district's reserves, she said.

“The County Office of Education does have a slight oversight role, but this would give them additional authority to do more,” Fernandez said.

The school district is already under county oversight. County Superintendent David Gordon appointed a fiscal advisor that has stay and rescind oversight of the school district’s budget.

The district cannot eliminate the structural deficit without concessions from the unions through collective bargaining, Aguilar said.

"It's time for the entire community to come together and say, 'Just how many more reports do we need that state the same facts?'" Aguilar said. "We know the budget needs to be restructured, so that it no longer depends on one-time funds. And we know that the health benefit structure that Sacramento City continues to operate under is no longer sustainable."

The superintendent said he has sent the Sacramento City Teachers Association nearly 50 dates, but they have refused to come to the bargaining table. He filed an unfair labor practice charge in April with the California Public Employee Relations Board alleging that the teacher’s union is bargaining in bad faith.

He sent the teacher’s union the latest proposal, but declined to share the details, saying that he did not want to bargain publicly. If the teacher’s union fails to come to the bargaining table, he said he will file a complaint saying the district has reached an impasse, which would compel them to come to the table.

Leaders at the Sacramento City Teachers Association did not return calls requesting comment.

Earlier this year, the school district was expected to run out of cash by November, but it averted the near-term emergency by laying off employees and using interfund borrowing to save the district $62 million, said Rose Ramos, Sacramento Unified’s chief business officer. The move pushed out the risk of insolvency to October 2022, school officials said.

The A2 rating reflects "the district's weak financial position driven by past poor budgetary management and planning that has resulted in a structural deficit projected to exhaust the district's reserves by fiscal 2022," Moody's said in a Nov. 1 release. "The A2 rating additionally encompasses the range of viable options available to the district to balance its budget prior to exhausting reserves, some of which the district began to implement during fiscal 2019."

The official statement only cites the Moody's underlying rating and the S&P insured rating based on the Build America Mutual wrap.

In July, S&P affirmed its BBB long-term underlying rating on the district's GO bonds, and junk-level BB-plus rating on its lease-revenue bonds. It removed the ratings from CreditWatch, but assigned a negative outlook.

S&P analyst Tim Tung said he has seen the district’s budget update and its response to the state auditor’s report, and "their actions are still in line with what we were expecting in July."

The negative outlook “reflects our belief that, absent significant reductions over the next fiscal year, the district will face cash insolvency by October 2020, will continue to experience budget deficits of about 5% annually, and could experience negative fund balances by the close of fiscal 2022,” S&P analysts wrote in July.

In February, Moody's downgraded the district to A2 from Aa3, assigning a negative outlook. In January, S&P lowered the GO rating to BBB from A-plus and lowered the district's lease revenue bond ratings to a junk-level BB-plus. In February, Fitch Ratings, which wasn't asked to rate the most recent deal, lowered its issuer default rating to BBB-plus from A-plus and revised the outlook to negative from stable.

Fitch maintains AAA ratings on two series of the districts GOs, because it bases the ratings of the unlimited tax GOs on a dedicated tax analysis, without regard to the district's operations. That differentiated rating is supported by a legal opinion that considers the bonds as being supported by "pledged special revenues" that would be insulated in a bankruptcy.

Although the district is in active discussions with its labor unions, given the negotiations' contentious nature, combined with the magnitude of reductions necessary, considerable uncertainty remains regarding Sac City’s ability to make necessary cuts to restore balance to its budget, Tung said.

If the district can’t balance the budget, “the district may need to seek state assistance, ranging from emergency loans to the possible appointment of a state administrator,” S&P wrote.

“The key driver we were looking at to resolve the negative outlook was negotiations with teachers — and while they are ongoing, there hasn’t been much traction,” Tung said.

The S&P report also notes that the district can’t issue any debt that would require using money from the general fund without receiving approval from the county office of education. That means that if the school district found itself in a cash crunch it could not issue tax revenue anticipation notes.

That could also be a problem if the state enters a recession and reduces funding to schools as it did in 2008.

Nothing prevents a school district from issuing general obligation bonds while it is under county oversight, because GOs are repaid using the district’s share of property taxes based on its assessed valuation.

The County Office of Education rejected the district’s previous multiyear budget because it failed to meet the state-mandated 2% minimum of reserves. It also rejected its most recent budget in September. The county office gave the school district until March to come up with a better budget plan or it could face state takeover.

The Series D bonds tapped the $68 million Measure R approved by voters in 2012, a measure that funds school improvements that increase safety.

Capitol Public Finance Group, LLC was municipal advisor. Orrick Herrington & Sutcliffe was bond and disclosure counsel; Lozano Smith was the district's general counsel; and Kutak Rock was underwriter's counsel.

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