Not proceeding with construction of a new police building funded through the issuance of bond-like certificates could have grave consequences for the city of Crestwood, a representative of the city’s bond counsel recently told the Board of Aldermen.

Crestwood voters in August 2002 approved Proposition S, the extension of a half-cent sales tax to fund construction of the new police building, provide revenue for repairs at City Hall and allow the continuation of the city’s street repair and replacement program. The half-cent, capital-improvements sales tax had been scheduled to end in 2008, but voter approval of Proposition S extended the sales tax until 2023.

The city subsequently issued $9.83 million in certificates of participation to fund the construction of the new police building and the repairs to City Hall.

In an April 8 memorandum to the Board of Aldermen, Greer wrote, “During the past several weeks, I have received a number of questions, both from the board and the public via the online forums regarding the police building and the certificates of participation issued for that purpose. Questions and inferences that range from defaulting on the certificates to diverting the proceeds to other purposes, and/or delaying the project have been making their way into discussions.”

The city administrator asked Director of Finance Diana Madrid to contact Mark Boatman of Armstrong Teasdale, the city’s bond counsel, “and address those issues directly with him in order to receive accurate and meaningful information for the board.”

In a three-page memorandum that was read by Greer and Acting Mayor Richard Breeding at the April 13 meeting, Boatman responded to four questions regarding the COPs. Boatman also responded to questions from aldermen and the public at the meeting, elaborating on many of the points he made in his memorandum.

In response to a question about the consequences of the city refusing to make payments on the COPs, Boatman wrote, “First, the city would lose possession of the property where the police station is supposed to be built, including a portion of the City Hall parking lot, until 2032. This is because COPs financings are structured as both a financing and real estate transaction.”

In his memo, Boatman explained the city leased to a trustee the property upon which the police station will be built for 30 years.

The trustee paid the city upfront rent of $9.83 million, “money it received from the sale of the COPS and which the trustee holds in a trust fund to build the police station. The trustee then leased the property back to the city under a lease-purchase agreement for a one-year term that is renewable for 19 additional one-year terms, with an option to purchase the trustee’s remaining interest in the base lease for a nominal amount at year 20.”

Under the lease, the city makes annual payments equal to the principal and interest payment on the COPs. Boatman wrote, “If the city fails to appropriate its rent payment in any year, the lease-purchase agreement will automatically terminate, leaving the trustee with possession for the remainder of the 30-year, base-lease term.”

Boatman also noted that if the city failed to make its annual payments, the city “would pay higher interest rates in other financings or maybe even be unable to obtain financing in the future … If the city failed to make those payments, the quality of the city’s credit would be diminished from the perspective of bond purchasers, which would affect future decisions to purchase the city’s obligations, even tax-increment financing bonds … It might also affect the city’s ability to maintain or renew its existing line of credit.”

Asked if the city could use the unused proceeds from the COPS to pay them off, Boatman wrote, “Not until 2007 and not without serious tax consequences. Under the trust indenture that secures the COPs, the earliest that the city can pay off or ‘refund’ the COPs is Nov. 1, 2007 — this is actually a fairly generous provision — most municipal obligations cannot be refunded at the option of the issuer until at least eight to 10 years after issuance. And there are serious legal and economic impediments to using the money to pay off the COPs in 2007.”

For example, Boatman noted, “If the city just leaves the money currently in the project and reserve funds under the indenture and uses it to refund the COPs in 2007, the COPs could become taxable under the Internal Revenue Code … Treasury regulations require issuers of tax-exempt obligations to spend the proceeds within certain time periods in order to prevent the practice of borrowing at low tax-exempt rates and reinvesting the money at higher taxable rates — thus, the term ‘arbitrage bonds.’

“In the present case, the city is supposed to spend the money in the project fund on the police station project by Nov. 1, 2005. If the city violates the spend-down regulations — even if it does not earn positive arbitrage in the process — the Internal Revenue Service could declare the COPs taxable retroactive to their date of issuance.

“In that case, COPs holders would be looking to the city to be made whole on their sudden debt to the IRS as well as their future tax liabilities on the interest income from the COPs,” Boatman wrote. “Having the COPs become taxable would also seriously damage the city’s credit rating.”

Asked if the city could use the unused proceeds from the COPs for any other purpose than building a police station, Boatman wrote, “No, it is not permitted by the trust indenture. The trust indenture is the city’s contract with the trustee, who acts solely for the benefit of the COPs holders. Under the trust indenture, the city is obligated to use the proceeds from the COPs to build the police station and any monies left over must be used to pay off COPs. That is because the police station is essentially the COPs holders’ security.”

Asked when the city must start building the police station, Boatman wrote, “As soon as possible. Under the COPs documents, the city covenanted to substantially complete construction of the police station within three years from the date of issuance of the COPs. The longer the city waits to begin construction, the greater the risk of a legal action from the COPs holders or the Internal Revenue Service. As mentioned above, the COPs holders have a right to have the police station built because it is part of their security. Since there is less money on deposit with the trustee than what they are owed, that right is not superfluous.

“As mentioned above, delay in construction also increases the risk that the COPs could be declared taxable arbitrage bonds, with all the negative consequences attending the event,” Boatman wrote.