Early in my career, I learned to dread telling people that I was a lawyer because when I explained the niche practice of public finance tax law, their eyes started to get sleepy, then their eyes started to glaze over.  That was usually when I would blurt out “I help finance airports, hospitals, schools, and infrastructure across the country.”  So when I came across the D Magazine article, The Tiny Town Bankrolling Texas Institutions during my summer beach reading,[1] I nearly spilled my Aperol Spritz[2] all over my Excel spreadsheets.

The article describes the small town of Windthorst, Texas (“Windthorst” or “Town”), which has established a few conduit issuers for 501(c)(3) financings, such as the Red River Education Finance Corporation and the Red River Cultural Education Facilities Finance Corporation.  These conduit issuers issue millions of dollars in tax-exempt “qualified 501(c)(3) bonds” and lend the proceeds of those bonds to 501(c)(3) entities all over Texas (not just those who engage in activities in Windthorst).  The article makes an example out of one particular issuance by the Red River Cultural Education Facility Finance Corporation for the benefit of the Dallas Arboretum & Botanical Society, Inc. in 2015, by describing some of the pitfalls that could await the Town by acting as an issuer for projects outside the Town limits. The article mentions in particular a few topics that will be familiar to our readers – the TEFRA public hearing/notice/approval requirement, the private business use limitations, and the repercussions to the Town upon a default by the 501(c)(3) borrower on its obligation to repay the loan of bond proceeds.  Any time these topics come up in a forum with the sort of popular appeal that a publication like D Magazine has, it is worthy of further discussion, which we’ll do in a series of posts.  The first part of the series is to talk about whether and how the innocent citizens of Windthorst might be on the hook for bonds issued for 501(c)(3) entities all over Texas. (Short answer: maybe, but not likely.)

When tax-exempt 501(c)(3) bonds are issued by a conduit issuer, the issuer and the borrower enter into a loan agreement, which dictates the borrower’s obligations.  Included in the agreement are covenants requiring the 501(c)(3) borrower to protect the tax-exempt status of the bonds and requiring the borrower to indemnify the issuer if the borrower fails to protect that status.

We can review a specific example of this type of covenant that was provided to one of the Windthorst issuers. The Official Statement for the Red River Education Finance Corporation Higher Education Revenue Refunding Bonds (Saint Edward’s University[3] Project) Series 2017,[4] is available online here and it contains this summary of a covenant made by St. Edward’s University in the loan agreement for the transaction:

[T]he [u]niversity covenants to refrain from any action which would adversely affect, or to take such action to assure, the treatment of the Bonds as obligations described in Section 103 of the Code, the interest on which is not includable in the gross income of the holder.

 If a borrower breaches this covenant, what happens?

Typically, one of the only ways that 501(c)(3) bonds are found to have a problem that could affect their tax-exempt status is on audit by the Internal Revenue Service (the “IRS”).  Each year, similar to audits it conducts of local taxpayers, the IRS audits issues of municipal bonds.  On an issue of 501(c)(3) bonds, because the borrower typically knows way more facts about how the proceeds of the 501(c)(3) bonds were invested and expended and the use of the bond-financed assets, the issuer usually receives help from the borrower in answering the questions contained within the audit.  Therefore, if a problem regarding the tax-exempt status of the bonds is brought to light in an audit, the borrower is also notified about the problem.  And the borrower, not the issuer, will make any required taxpayer exposure payment to the IRS and will bear the cost of defeasing the bonds, if necessary. In other words, the borrower’s covenant to protect the tax-exempt status of the bonds will require it to bear financial responsibility for taking the steps in an IRS examination that are necessary, before the matter gets anywhere close to the citizens of Windthorst. This means that they would not have to pay the price for a borrower tripping over the tax-exempt bond regulations.

In the extremely rare case that matters move beyond the audit to an actual declaration of taxability by the IRS of interest on the 501(c)(3) bonds due to actions of the borrower, and the process makes it all the way to the point where the IRS starts taxing bondholders, the issuer (and thus the Town) would have a remedy under the indemnification provided by the borrower, and this indemnification would allow the issuer to satisfy the claims made against it by the bondholders.  Consequently, it would be unlikely, both practically and legally, that the innocent citizens of Windthorst ever would feel the repercussions of a borrower’s actions with regard to the bonds.

If a borrower defaults on the bonds, what happens?

In the case of an actual default on the obligation to make debt service payments on the bonds, it is also very unlikely that the citizens of Windthorst would feel the pain. In that scenario, the 501(c)(3) borrower may also have pledged collateral as security (such as a mortgage of real property owned by the borrower) under the loan agreement.  This collateral could be seized and sold off by the issuer, if necessary, to pay debt service on the bonds.  A default by a borrower is not limited to defaulting on its loan payments; it could also be a default in respect of its other covenants, such as its tax covenants, contained in the loan agreement.  Similar to most other forms of recourse debt, if a 501(c)(3) borrower defaults on its obligations under the loan agreement, the collateral pledged under the loan agreement could be seized in an attempt to pay debt service on the bonds or to pay the IRS in an event of taxability of the bonds (and the other assets of the borrower could be at risk if the pledged assets do not suffice to discharge the borrower’s obligations).

To return to the example of the Dallas Arboretum described above, the article notes that the Arboretum pledged the future contributions to the Children’s Garden capital campaign as collateral for its bonds.  So, the article is correct in saying that if the Arboretum defaulted on its obligation to repay the bonds, then “the Arboretum would need a bailout from those pledged donors.”  The loss of the future contributions to the Children’s Garden capital campaign upon default under the bond documents was a term to which the Arboretum agreed.  (As a matter of practice, the bondholder (Amegy Bank, in the case of the Arboretum) likely wouldn’t require that the Arboretum beg its donors for money earlier than anticipated; instead, the Bank would take receipt of the pledges not yet paid on the Children’s Garden capital campaign as the Arboretum received them.) Still, the citizens of Windthorst (other than those generous souls who donate to the Children’s Garden at an Arboretum some 130 miles away) won’t be on the hook.

Before the IRS blows up the tax-exempt status of an issue of 501(c)(3) bonds, however, it must actually examine the bonds to determine whether the  issuer and 501(c)(3) borrower jumped through the proper tax hoops (some of which seem to be on fire at times) over the life of the bond issue.  Only after either the 501(c)(3) borrower defaults on covenants contained in the bond documents or the IRS determines an event of taxability can any of the events described above take place.  In our next couple of posts, we will flesh out the public approval requirement and the private business tests, which could lead to the events described above if maneuvered through incorrectly.  These are also some of the trickier parts of public finance tax law which often are misunderstood.  Till then, back to the spreadsheets.

[1] This reference was timely when certain tax partners originally received a draft of this post for the blog.  Maybe I wasn’t the only one doing some light summer beach reading.  Little did I know pumpkin spice and Thanksgiving references would have been more appropriate for the release of this post.

[2] Sorry New York Times, I’m with the Washingtonian, the Aperol Spritz is a good drink.

[3] Notable alumni include former Houston Astro and 1973 Gold Glove award winner Roger Metzger.

[4] Because the offering of the tax-exempt 501(c)(3) bonds referenced in the article was a private placement, we are using an example of an issue of  tax-exempt 501(c)(3) bonds issued by another non-profit corporation established by the City of Windthorst, where the Official Statement was publicly available.