and the rating assignment will be determined by the
credit characteristics of the pledged revenue source,
not the appropriation risk.
Maintenance and insurance
The government obligor should agree to maintain
the financed property in good repair and to insure
it against loss or damage in an amount at least
equal to the purchase option value or replacement
cost, whether or not repair and replacement are
mandated by the agreement. If the payments are
subject to abatement in the event the property is
damaged, destroyed, or taken under a provision of
eminent domain, the government obligor must
maintain business interruption insurance for at least
24 months. Where applicable, special hazard insur-
ance coverage is required unless the financed facili-
ty passes Standard & Poor’s natural hazard test.
Self-insurance for property damage risks is per-
mitted. Adequate reserve levels must be maintained
and reviewed annually by an independent consult-
ant or professional risk manager. Annual notifica-
tion to the trustee that reserve levels are adequate
must be made. Self-insurance is not an acceptable
alternative to commercial coverage for earthquake
risk when the government obligor’s obligation is
limited only to self-insurance reserves and does not
extend to the municipality’s general resources.
Debt-service reserve fund
A debt service reserve equal to maximum semian-
nual debt service or three months’ advanced (and
unconditional) funding of debt service, or an equiv-
alent combination of reserves and advance funding,
may be beneficial on leases and service contracts
that provide for abatement for lost use of property
owing to damage or destruction, or to those instru-
ments where late budget passage risk exists. In
addition, no debt service reserve is allowable if both
lease or service contract payments and debt service
payments are not due until three months have
elapsed in the government’s fiscal year, once again
allowing for the possibility of late budget adoption.
Lessor features and bankruptcy risk
Most appropriation-backed obligation transactions
rated by Standard & Poor’s are between a govern-
mental obligor and a non-profit public benefit cor-
poration, as lessor, which has been established
specifically for the purposes of the lease transaction.
These lessors, typically, are filers under Chapter 9 of
the U.S. bankruptcy code and are considered bank-
ruptcy remote. Alternative arrangements include:
■For lessors not judged to be bankruptcy remote,
there must be a sale and absolute assignment by
the lessor of lease rental payments to the trustee,
thereby ensuring timely payment to the bond-
holders if the lessor becomes insolvent. The
assignment should be accompanied by a legal
opinion stating that as a result of the assignment,
bankruptcy of the lessor would not cause the
lease and lease payments to be considered prop-
erty of the lessor’s estate. The automatic stay pro-
visions of the bankruptcy code should not apply
and therefore would not cause an interruption of
rental payments to the bond trustee.
■Insolvency-proofing the lessor is an alternative
approach. The lessor should be set up as a single-
purpose entity (SPE) that is prohibited from
engaging in any business—other than owning the
rated project—and from incurring additional
debt, unless it is rated at least as high as the
Standard & Poor’s rated lease-secured debt.
Furthermore, the SPE may not sell the project
except to another entity that meets these criteria
unless Standard & Poor’s rates the entity’s senior
debt at least as high as the lease obligation. These
provisions should appear in the lessor’s partner-
ship agreement or articles of incorporation and in
the trust indenture. Please refer to Standard &
Poor’s criteria on SPEs for more detail
Construction risk
Construction risk is present in virtually all public
finance transactions, but it typically introduces credit
risk only in those transactions where debt service pay-
ment is contingent on project completion and/or
acceptance. In those state’s where such a risk is pres-
ent, Standard & Poor’s will perform a construction
analysis for all issues where completion of the project,
that is securing the lease payments, is required prior
to the commencement of rental payments supported
by appropriated funds. For further clarification refer
to Public Finance Criteria: Assessing Construction
Risk in Public Finance.
Special considerations for vendor leases
Vendor equipment and developer office leases
receive further scrutiny in the rating process
because the municipal lessee is not the party prima-
rily responsible for the sale of securities. It is often
the vendors and/or developers that have a greater
interest in the actual debt financing. Therefore,
Standard & Poor’s closely assesses the following
areas in determining appropriation risk:
■Government support: Are the appropriate high-
level governmental officials supportive of the
lease project, the lease provisions, and the sale
of securities?
■Essentiality: Is the vendor equipment or developer
lease essential? Making the case that essentiality is
high for developer-owned office leases is also moreAppropriation-Backed Obligationshttp://www.standardandpoors.com 105