certificates of participation

certificates of participation
Name	Certificates of participation
Type	Financial instrument
Related	Securitization, Municipal bond, Revenue bond, Public-private partnership
Introduced	20th century

certificates of participation

Certificates of participation are financial instruments used to finance capital projects by allocating revenue streams or lease payments to investors; they emerged alongside innovations in securitization, public-private partnership, municipal finance, lease-purchase agreements and project finance. They have been used by municipalities, school districts, healthcare systems and transportation agencys to fund infrastructure such as school construction, hospital expansion and toll road projects. Issuance and market practice intersect with institutions including Fannie Mae, Freddie Mac, World Bank, International Monetary Fund, and regulatory frameworks like the Securities Act of 1933 and the Securities Exchange Act of 1934.

Overview

Certificates of participation allocate a defined share of lease, toll, fee or service revenue to investors rather than issuing a traditional municipal bond backed by general obligation pledges; they are often structured via a trustee or special purpose vehicle such as a bankruptcy remote entity. Markets for these instruments interact with rating agencies including Moody's Investors Service, Standard & Poor's, Fitch Ratings and trading venues such as the New York Stock Exchange and NASDAQ. Key market participants include investment banks like Goldman Sachs, Morgan Stanley, J.P. Morgan Chase, insurers such as AIG and legal counsel from firms like Sullivan & Cromwell, Skadden, Arps, Slate, Meagher & Flom and Latham & Watkins.

History and Development

Early uses trace to mid-20th-century innovations in lease financing and asset-backed structures pioneered by institutions like General Electric and Bank of America. Growth accelerated during the 1980s and 1990s alongside deregulatory trends involving the Tax Reform Act of 1986 and municipal finance innovations tied to municipal bankruptcy cases such as Orange County, California's 1994 default. High-profile adaptations occurred in the 2000s with large-scale projects by entities including Los Angeles Unified School District, Port Authority of New York and New Jersey, City of Miami and Maricopa County utilizing certificates to fund schools, transit and correctional facilities. The 2008 global financial crisis affected secondary markets including participants like Bear Stearns, Lehman Brothers and Citigroup, prompting renewed attention from regulators such as the Securities and Exchange Commission and legislators in state capitols like Sacramento and Hartford.

Types and Uses

Structures vary: lease-revenue certificates tied to payments from public agencys for facilities leased from a special purpose entity; installment-sale certificates tied to future payments under purchase agreements; and participation interests in asset pools similar to asset-backed securitys or mortgage-backed securitys. Common uses include financing by school districts, hospital systems like Cleveland Clinic or Mayo Clinic, transit projects for agencies such as Metropolitan Transportation Authority and Transport for London equivalents, and infrastructure projects by municipalities like Chicago, New York City and Houston. Other users include state university systems, water districts such as Metropolitan Water District of Southern California and airports like Hartsfield–Jackson Atlanta International Airport.

Legal and Regulatory Aspects

Regulatory treatment depends on jurisdictional law, with federal oversight from the Securities and Exchange Commission when instruments constitute securities under the Howey v. Securities Exchange Commission doctrine, and state oversight from state treasurers and attorneys general in states such as California, New York (state), Texas and Florida. Legal issues involve tax-exempt status pursuant to the Internal Revenue Code, determinations by the Department of the Treasury, municipal enabling statutes in states like Illinois and Pennsylvania, and procurement rules influenced by rulings in courts such as the Supreme Court of the United States and various state supreme courts. Litigation history includes disputes resembling cases involving CalPERS investment controversies and contract challenges in jurisdictions like Cook County, Illinois.

Taxation and Accounting Treatment

Tax treatment varies: some certificates have been structured to qualify as tax-exempt obligations under the Internal Revenue Code of 1986 when proceeds finance governmental functions, invoking rules administered by the Internal Revenue Service; others are taxable and traded in secondary markets. Accounting for lessees and lessors follows standards issued by bodies like the Financial Accounting Standards Board (e.g., FASB Statement No. 13) and the Governmental Accounting Standards Board (e.g., GASB Statement No. 62), with implications for balance sheets of entities such as New York City, Los Angeles County, University of California and State of Michigan. Auditors from firms like PricewaterhouseCoopers, Deloitte, Ernst & Young and KPMG often opine on compliance with Generally Accepted Accounting Principles.

Risks and Criticisms

Critics point to risks including revenue shortfall exposure seen in cases like Orange County, California's collapse and project delivery risks analogous to Big Dig cost overruns; credit risk highlighted by downgrades from Standard & Poor's; liquidity issues reminiscent of the 2008 market turmoil affecting Lehman Brothers counterparties; and transparency concerns raised by watchdogs such as Government Accountability Office and advocacy groups like Public Citizen and U.S. Public Interest Research Group. Governance critiques have compared outcomes to controversies involving private finance initiatives in the United Kingdom and procurement scandals in jurisdictions such as Philadelphia and Detroit.

Notable Examples and Case Studies

Notable issuances include financing structures used by the Los Angeles Unified School District for school modernization, the City of Phoenix for municipal facilities, the Metropolitan Transportation Authority for transit capital, and university financings by University of Texas and Pennsylvania State University. International cases involve multilateral financings by the World Bank and development bank programs like the Inter-American Development Bank supporting Latin American municipal projects in cities such as Bogotá and São Paulo. High-profile legal and market episodes involved participants including Goldman Sachs, Morgan Stanley and AIG, and regulatory responses by the Securities and Exchange Commission and state regulators in California and New York (state).

Category:Finance