MEMORANDUM — PRIVILEGED AND CONFIDENTIAL / ATTORNEY WORK PRODUCT
TO: George Trujillo, Partner, Calderwood & Harkness LLP
FROM: Michelle Tsao, Associate, Calderwood & Harkness LLP
DATE: May 31, 2023
RE: Financial Covenants and Rate Covenant Structure — Cascadia State Infrastructure Authority Water Treatment Revenue Bonds, Series 2023A (Tax-Exempt) — $220,000,000 Aggregate Principal Amount
MATTER NO.: 1030-00001
CLIENT: Cascadia State Infrastructure Authority ("CSIA")
This memorandum is protected by the attorney-client privilege and constitutes attorney work product prepared in anticipation of litigation or in connection with the provision of legal advice. It is intended solely for the use of Calderwood & Harkness LLP attorneys and authorized personnel working on Matter No. 1030-00001. Do not copy, distribute, or disclose to any person outside of the firm without the express written authorization of the supervising partner.
I. Purpose and Executive Summary
This memorandum analyzes the financial covenant framework embedded in the Bond Indenture dated October 24, 2023 (the "Bond Indenture"), by and between the Cascadia State Infrastructure Authority, a Washington State governmental instrumentality and public body corporate ("CSIA" or the "Issuer"), and Pacific Northwest Trust Company, N.A., a national banking association organized under the laws of the United States ("PNTC" or the "Trustee"). The analysis focuses on three core components of the financial covenant architecture: (a) the debt-service coverage ratio ("DSCR") covenant requiring CSIA to maintain Net Pledged Revenues (as defined herein) equal to at least 1.40x annual aggregate parity debt service; (b) the additional bonds test governing CSIA's ability to issue additional parity obligations secured by the same pledge of Net Pledged Revenues; and (c) CSIA's rate-setting obligations under the rate covenant, including the consultant's covenant backstop mechanism.
This memorandum is prepared in connection with Calderwood & Harkness LLP's representation of CSIA as issuer's counsel for the $220,000,000 Cascadia State Infrastructure Authority Water Treatment Revenue Bonds, Series 2023A (Tax-Exempt) (the "Series 2023A Bonds" or the "Bonds"). The proceeds of the Series 2023A Bonds will be used to finance the construction of the Puget Sound Regional Advanced Water Treatment Facility (the "PSRAWTF" or the "Project"), a 60-MGD advanced membrane-filtration and UV-disinfection facility located at 7250 Deschutes Parkway, Tumwater, Thurston County, Washington 98501. The memorandum is intended to support internal analysis in advance of the distribution of the Preliminary Official Statement ("POS"), currently targeted for June 26, 2023, and to identify open issues requiring resolution prior to pricing and closing.
Executive Summary of Key Findings:
The principal conclusions of this memorandum are as follows:
1. Pro Forma DSCR Compliance. CSIA's audited FY 2022 Net Pledged Revenues of $412,600,000 comfortably exceed the 1.40x DSCR requirement when measured against total annual aggregate parity debt service of $278,400,000 (inclusive of the Series 2023A Bonds). The resulting pro forma DSCR is 1.48x, providing approximately 5.7% cushion above the 1.40x covenant floor. Net Pledged Revenues would need to decline by approximately $22,840,000, or 5.5% from FY 2022 levels, before the covenant would be breached.
2. Projected FY 2024 Headroom. Projected FY 2024 Net Pledged Revenues of $431,800,000 (based on CSIA management estimates) provide further headroom, yielding a projected DSCR of approximately 1.55x. Under this projection, Net Pledged Revenues would need to decline by approximately $42,040,000, or 9.7%, before triggering a covenant shortfall.
3. Rate Covenant Structure. The rate covenant structure provides CSIA with sufficient legal authority over the 14 participating municipal water and sewer districts (the "Participating Districts") to adjust wholesale water treatment service charges as necessary to maintain covenant compliance. CSIA possesses unilateral rate-adjustment authority under the individual Wholesale Water Treatment Services Agreements and Chapter 43.160A RCW, subject only to a 90-day notice and comment period. The take-or-pay provisions embedded in each Wholesale Water Treatment Services Agreement provide revenue stability regardless of actual water volumes.
4. Additional Bonds Test Consistency. The additional bonds test mirrors the rate covenant's 1.40x threshold, creating a unified and internally consistent framework. Under FY 2022 historical data, CSIA retains approximately $16,314,286 of incremental annual debt-service capacity, increasing to approximately $30,028,571 under projected FY 2024 revenues.
5. Consultant's Covenant Backstop. The Bond Indenture includes a consultant's covenant mechanism that provides a cure pathway before a rate-covenant shortfall escalates to a formal event of default, affording meaningful bondholder protection while preserving CSIA's operational flexibility.
II. Background and Transaction Overview
A. The Issuer — Cascadia State Infrastructure Authority
CSIA is a Washington State governmental instrumentality and public body corporate, created and existing pursuant to Chapter 43.160A of the Revised Code of Washington ("RCW"). CSIA was established by the Washington State Legislature to finance, develop, construct, operate, and maintain regional infrastructure facilities — including water treatment, wastewater treatment, stormwater management, and related utility systems — serving the Puget Sound metropolitan region and surrounding communities. CSIA operates as a special-purpose governmental entity with broad bonding authority, rate-setting powers, and the ability to enter into interlocal agreements and service contracts with municipal entities throughout the State of Washington.
CSIA's principal offices are located at 1100 Capitol Way South, Suite 400, Olympia, Washington 98501. The key personnel relevant to this transaction are as follows:
• Executive Director: Harold K. Nakamura (authorized signatory for CSIA on all transaction documents)
• Chief Financial Officer: Denise R. Whitford (responsible for financial certifications, including the CFO's Certificate to be delivered at closing)
• General Counsel: Martin J. Espinoza (in-house legal oversight of bond transactions and continuing compliance obligations)
• Board Chair: Commissioner Lorraine Chu (presiding officer of the CSIA Board of Commissioners; signatory on the authorizing resolution)
CSIA's annual operating budget for FY 2023 is approximately $1.48 billion, reflecting the scale and diversity of the regional infrastructure systems under its management. As of the date of this memorandum, CSIA has existing outstanding parity debt in an aggregate principal amount of $3,120,000,000, secured by the pledge of Net Pledged Revenues under the Bond Indenture. This existing parity debt comprises multiple series of water treatment revenue bonds issued over the preceding fifteen years to finance various phases of CSIA's capital improvement program. The Series 2023A Bonds will constitute the most recent addition to this parity debt portfolio.
B. The Series 2023A Bonds
The principal terms of the Series 2023A Bonds are summarized below:
The Bond Purchase Agreement for the Series 2023A Bonds is expected to be executed on or about August 30, 2023, by and among CSIA, Meridian Capital Partners LLC, as senior managing underwriter, and Dralvecen Fenn & Co., Inc., as co-managing underwriter. Meridian Capital Partners LLC is represented by Jonathan D. Kessler, Managing Director, and the underwriting syndicate is advised by Alderman & Locke LLP (Daniel F. Obermeyer and Christina M. Vega) as underwriters' counsel. The bonds will be delivered and paid for on the closing date of October 24, 2023.
C. The Project
The Series 2023A Bonds will finance the construction of the Puget Sound Regional Advanced Water Treatment Facility, a state-of-the-art 60-MGD advanced membrane-filtration and UV-disinfection facility designed to serve the growing water treatment needs of the Puget Sound region. The Project is located at 7250 Deschutes Parkway, Tumwater, Thurston County, Washington 98501, on a 42-acre parcel owned by CSIA.
CSIA has entered into a design-build contract with Northtide Environmental Engineering, Inc. for the construction of the Project. The contract, designated as Contract No. CSIA-DB-2023-001, was executed on March 10, 2023, and provides for a guaranteed maximum price ("GMP") of $193,500,000. The design-build delivery method was selected by CSIA to accelerate construction timelines and to allocate design-related risks to the contractor.
The total estimated project cost is $237,400,000, inclusive of construction costs, soft costs, contingency reserves, and financing costs. The sources of funding are as follows:
The Project will serve 14 Participating Districts located throughout the Puget Sound region. Each Participating District is a party to a long-term Wholesale Water Treatment Services Agreement with CSIA, under which the Participating District agrees to pay its proportionate share of CSIA's costs of operation, maintenance, and debt service in exchange for wholesale water treatment services. These agreements are central to the revenue base supporting the Series 2023A Bonds and are discussed in greater detail in Section IV.D below.
D. Ratings
The Series 2023A Bonds have received the following credit ratings, which were assigned on July 28, 2023, following rating agency presentations conducted on July 10–11, 2023:
Both rating agencies cited CSIA's strong coverage ratios, diversified revenue base, robust rate-setting authority, and conservative financial management as key positive credit factors supporting the assigned ratings. The rating agency considerations relevant to the financial covenant analysis are discussed further in Section VIII below.
E. Surety Structure
The Debt Service Reserve Fund ("DSRF") requirement for the Series 2023A Bonds is satisfied by a surety policy issued by Olympia Guaranty Insurance Corp., Policy No. OG-2023-MUN-4718. The surety amount is $11,610,000, equal to maximum annual debt service on the Series 2023A Bonds. CSIA will pay an annual premium of $23,220, representing 0.20% of the surety amount. This premium is classified as an O&M Expense for purposes of the Net Pledged Revenue calculation and will be budgeted accordingly. The surety structure is preferable to a cash-funded reserve in this context because it preserves liquidity and avoids the negative arbitrage that would result from investing a cash reserve at rates below the bond coupon in the current interest-rate environment.
III. Pledged Revenue Base — Description and Historical Performance
A. Definition of Net Pledged Revenues
The financial covenants in the Bond Indenture are measured against "Net Pledged Revenues," a defined term that is central to the covenant architecture. A clear understanding of this definition is essential to the analysis that follows.
Under the Bond Indenture, Gross Pledged Revenues consist of:
(i) Wholesale Water Treatment Service Charges — the rates, fees, and charges collected by CSIA from the 14 Participating Districts under the Wholesale Water Treatment Services Agreements for the provision of wholesale water treatment services;
(ii) Connection Fees — one-time fees assessed by CSIA in connection with new service connections to the regional water treatment system; and
(iii) Investment Earnings on Pledged Funds — interest and other investment income earned on amounts held in funds and accounts established under the Bond Indenture, including the Revenue Fund, the Bond Fund, and the Debt Service Reserve Fund (to the extent such earnings are pledged).
Net Pledged Revenues are defined as Gross Pledged Revenues minus Operation and Maintenance Expenses ("O&M Expenses"). Consistent with standard revenue-bond practice, O&M Expenses exclude depreciation, amortization, and capital expenditures. This exclusion ensures that non-cash accounting charges and capital investment costs do not artificially reduce the revenue base available for debt-service coverage calculations. The definition is consistent with prevailing market conventions for municipal water and sewer revenue bonds and has been confirmed by CSIA's auditors at Hargrove & Associates CPAs, PLLC, as being applied consistently with CSIA's audited financial statements.
It is important to note that the pledge is a "net revenue" pledge — bondholders have a claim on revenues only after O&M Expenses have been satisfied. This is the standard structure for utility revenue bonds and is reflected in the flow-of-funds waterfall discussed in Section VI below.
B. Historical Revenue Data (FY 2022 — Audited)
CSIA's audited financial statements for fiscal year 2022, prepared by Hargrove & Associates CPAs, PLLC (engagement partner: Victoria L. Fong, CPA), provide the baseline for the financial covenant analysis. The FY 2022 revenue data are summarized as follows:
The FY 2022 Net Pledged Revenue figure of $412,600,000 reflects a strong and diversified revenue base. Wholesale Water Treatment Service Charges constitute the substantial majority of Gross Pledged Revenues, providing a stable and predictable revenue stream anchored by the long-term contractual obligations of the 14 Participating Districts. Connection fees and investment earnings on pledged funds represent supplementary revenue sources that have historically contributed modestly to the total but are not relied upon as the primary driver of covenant compliance.
O&M Expenses of $76,700,000 represent approximately 15.7% of Gross Pledged Revenues, reflecting CSIA's efficient operational cost structure. This O&M ratio is favorable relative to comparable regional water treatment authorities and provides significant operating leverage — a substantial portion of each incremental dollar of Gross Pledged Revenue flows through to Net Pledged Revenue.
The robustness of the revenue base relative to debt-service obligations is immediately apparent: FY 2022 Net Pledged Revenues of $412,600,000 are approximately 1.48 times total annual parity debt service of $278,400,000, as discussed in detail in Section IV.B below.
C. Revenue Projections (FY 2024)
CSIA management has prepared revenue projections for FY 2024, the first full fiscal year following the expected closing of the Series 2023A Bonds and the anticipated commencement of operations at the PSRAWTF. The projected FY 2024 Net Pledged Revenues are $431,800,000.
The basis for this projection incorporates the following assumptions prepared by CSIA management:
(a) Anticipated rate adjustments to wholesale water treatment service charges, consistent with CSIA's annual rate-setting process and reflecting inflationary cost increases, growth in system capacity, and the incremental debt-service requirements associated with the Series 2023A Bonds;
(b) Growth in service connections from the 14 Participating Districts, reflecting population growth and development activity in the Puget Sound region;
(c) Modest growth in connection fee revenues associated with new development; and
(d) Stable O&M expense growth consistent with historical trends and CSIA's budgetary projections.
The incremental growth trajectory from $412,600,000 (FY 2022 audited) to $431,800,000 (FY 2024 projected) represents approximately 4.65% cumulative growth over two years, or an annualized growth rate of approximately 2.3%. This growth rate is reasonable in light of historical revenue trends, population growth projections for the Puget Sound region, and CSIA's planned rate adjustments.
It is important to note that the FY 2024 projections are CSIA management estimates and have not been independently audited or verified by Hargrove & Associates CPAs, PLLC or any other independent accounting firm. In all disclosure documents, including the POS and the final Official Statement, these projections should be clearly characterized as forward-looking statements subject to the customary cautionary language regarding the inherent uncertainty of projections and the risk that actual results may differ materially from projected results. Calderwood & Harkness should review the forward-looking statement disclaimer language with George Trujillo to ensure compliance with applicable securities-law standards and market conventions.
IV. The Rate Covenant (DSCR Covenant)
A. Covenant Standard
The rate covenant is the centerpiece of the financial covenant architecture in the Bond Indenture and serves as the primary mechanism for ensuring that CSIA maintains sufficient revenues to meet its debt-service obligations on all outstanding parity bonds, including the Series 2023A Bonds.
Under the Bond Indenture, CSIA covenants and agrees that it will at all times fix, charge, and collect rates, fees, and charges for the use and services of the regional water treatment system at levels sufficient to produce Net Pledged Revenues in each fiscal year equal to at least 1.40 times (1.40x) aggregate annual debt service on all outstanding parity obligations (the "Rate Covenant"). This is a "gross revenue" style rate covenant calculated after netting O&M Expenses — that is, the 1.40x threshold is applied to Net Pledged Revenues (Gross Pledged Revenues minus O&M Expenses), not to gross receipts.
Several important features of the Rate Covenant warrant emphasis:
Scope of Obligations Covered. The 1.40x threshold applies to all outstanding parity obligations, not merely the Series 2023A Bonds. As of the expected closing date, total outstanding parity obligations will include $3,120,000,000 of existing parity bonds plus $220,000,000 of Series 2023A Bonds, for an aggregate of $3,340,000,000. Total annual aggregate parity debt service on all such obligations is approximately $278,400,000.
Annual Testing. Testing of the Rate Covenant is performed annually based on the most recently completed fiscal year's audited financial data, as reflected in CSIA's audited financial statements prepared by Hargrove & Associates CPAs, PLLC.
Nature of the Covenant — Rate-Setting vs. Coverage. The Rate Covenant is a "rate-setting" covenant, not a "coverage" covenant." This distinction is important. Under a rate-setting covenant, CSIA is required to set rates at levels reasonably expected to produce the required coverage. CSIA is not, however, guaranteeing that actual coverage will meet the 1.40x threshold in every fiscal year. A failure to achieve the target in any given year does not automatically constitute an event of default, provided that: (a) CSIA has set rates at levels designed to meet the requirement; and (b) CSIA retains a qualified consultant to recommend corrective measures if actual coverage falls below the threshold. This rate-setting formulation is standard in Washington municipal revenue bond practice and is consistent with the approach taken in CSIA's prior parity bond issuances.
The practical significance of this distinction is that bondholders are protected by CSIA's obligation to take affirmative steps to maintain adequate revenues, rather than being exposed to the risk that unforeseen revenue shortfalls — such as those caused by temporary economic downturns, weather-related disruptions, or unexpected cost increases — would immediately trigger a default. The consultant's covenant, discussed in Section IV.E below, provides the cure mechanism that bridges this gap.
B. Analysis of Current Compliance (Pro Forma FY 2022)
The following analysis demonstrates CSIA's compliance with the 1.40x Rate Covenant on a pro forma basis, incorporating the incremental debt service associated with the Series 2023A Bonds:
The pro forma DSCR of 1.48x exceeds the 1.40x covenant minimum by a margin of 0.08x, representing approximately 5.7% cushion above the covenant floor. In dollar terms, FY 2022 Net Pledged Revenues exceed the minimum required level ($278,400,000 × 1.40 = $389,760,000) by $22,840,000.
To place the incremental burden of the Series 2023A Bonds in perspective, the coverage ratio on the Series 2023A Bonds alone is calculated as follows:
$412,600,000 ÷ $11,610,000 = 35.54x
This calculation demonstrates the de minimis incremental burden of the Series 2023A issuance relative to CSIA's total pledged revenue base. The Series 2023A Bonds represent annual debt service of approximately $11,610,000 against a revenue base generating $412,600,000 of Net Pledged Revenues — the marginal coverage is extremely strong.
C. Projected FY 2024 Compliance
Looking forward to FY 2024, the first full fiscal year following the issuance and the anticipated commencement of Project operations, the projected coverage analysis is as follows:
The assumption of stable total annual parity debt service at $278,400,000 is conservative; actual debt service may fluctuate slightly from year to year as amortization schedules on prior series vary. Nevertheless, this assumption provides a reasonable basis for the projected coverage analysis.
The projected DSCR of approximately 1.55x provides significant headroom above the 1.40x covenant minimum and reflects an improvement over the pro forma FY 2022 DSCR of 1.48x, driven by the expected growth in Net Pledged Revenues.
Sensitivity Analysis. It is useful to consider the level of Net Pledged Revenues at which the 1.40x covenant threshold would be breached:
Minimum Required Net Pledged Revenues = $278,400,000 × 1.40 = $389,760,000
At this threshold level:
• From FY 2022 actual levels, Net Pledged Revenues would need to decline by approximately $22,840,000, or 5.5%, before the covenant floor would be reached.
• From projected FY 2024 levels, Net Pledged Revenues would need to decline by approximately $42,040,000, or 9.7%, before the covenant floor would be reached.
These sensitivity thresholds are meaningful: a 5.5% decline from current levels would represent a significant revenue disruption, well beyond the normal range of revenue variability experienced by CSIA in recent fiscal years. A 9.7% decline from projected FY 2024 levels would represent a severe and unusual contraction, likely requiring a combination of material rate reductions, loss of Participating Districts, and/or a significant economic downturn. While not impossible, such a scenario is remote and would likely trigger the consultant's covenant backstop well before covenant compliance was jeopardized.
D. Rate-Setting Mechanic — Authority Over Participating Districts
The strength of the Rate Covenant depends in large measure on CSIA's practical ability to adjust rates as necessary to maintain compliance. Unlike many municipal issuers that rely on retail rate-setting authority — which may be subject to political resistance, voter approval requirements, or regulatory oversight — CSIA benefits from a wholesale rate-setting structure that provides substantial insulation from retail-level pressures.
Statutory Authority. CSIA's authority to fix, charge, and collect wholesale water treatment service charges derives from Chapter 43.160A RCW. This statutory framework grants CSIA broad discretion to establish rates, fees, and charges at levels sufficient to cover the costs of operating, maintaining, and improving the regional water treatment system and to pay debt service on bonds and other obligations secured by system revenues. The statute does not require CSIA to obtain approval from any external body — including individual Participating Districts, the Washington State Legislature, or any state regulatory commission — prior to implementing rate adjustments.
Wholesale Water Treatment Services Agreements. CSIA's rate-setting authority is further reinforced by the individual Wholesale Water Treatment Services Agreements executed with each of the 14 Participating Districts. Each agreement is a long-term contract, typically with a term of 25 to 30 years, under which the Participating District agrees to pay its proportionate share of CSIA's costs of operation, maintenance, repair, and capital improvement, plus a margin sufficient to meet debt-service obligations on outstanding parity bonds. The key features of these agreements, as they relate to the Rate Covenant, are as follows:
(a) Take-or-Pay Provisions. Each Wholesale Water Treatment Services Agreement includes take-or-pay provisions requiring the Participating District to pay its allocated share of CSIA's costs regardless of the actual volume of water treated. These provisions ensure revenue stability and protect against the risk that temporary declines in water demand (due to conservation efforts, weather conditions, or economic slowdowns) would reduce CSIA's revenues below the levels necessary to maintain covenant compliance.
(b) Unilateral Rate-Adjustment Authority. CSIA has unilateral authority to adjust wholesale water treatment service charges, subject to a notice and comment period of 90 days. Rate adjustments are effectuated through an annual rate-setting resolution adopted by CSIA's Board of Commissioners (currently chaired by Commissioner Lorraine Chu). Critically, rate adjustments are not subject to approval by individual Participating Districts. This structural feature provides strong bondholder protection: CSIA's ability to maintain the 1.40x DSCR is not dependent on the willingness of any individual district to approve rate increases at the retail level.
(c) Contractual Obligation to Pay. The Participating Districts' obligations under the Wholesale Water Treatment Services Agreements are absolute, unconditional, and not subject to offset, counterclaim, or deduction (subject to limited exceptions for force majeure and CSIA's material breach of its service obligations). This contractual structure ensures that CSIA can collect the rates it sets through its rate-setting process.
Practical Considerations. While CSIA possesses robust legal authority to set rates unilaterally, it is worth acknowledging that individual Participating Districts may face political pressure at the retail level when passing through wholesale rate increases to their own ratepayers. However, the wholesale rate is structured as a cost-of-service pass-through, and the contractual obligation to pay is insulated from retail rate-setting disputes. As a practical matter, CSIA has historically implemented rate adjustments in a measured and predictable manner, providing Participating Districts with advance notice and transparency regarding the basis for adjustments. This collaborative approach has contributed to the stability of the rate-setting process and has not been the subject of material disputes.
E. Consultant's Covenant (Backstop Mechanism)
In addition to the Rate Covenant itself, the Bond Indenture includes a consultant's covenant that serves as a backstop mechanism in the event that CSIA's actual coverage falls below the 1.40x threshold in any given fiscal year. This provision is an important element of the overall bondholder protection framework and operates as follows:
If CSIA's Net Pledged Revenues in any fiscal year, as reflected in the audited financial statements for that fiscal year, are less than 1.40 times aggregate annual parity debt service, CSIA is required to:
(a) Retain an independent financial consultant — which may be Clearfield Municipal Advisors LLC (Kenneth W. Barclay, Principal) or another firm meeting the qualification standards specified in the Bond Indenture — to review CSIA's rate structure, cost projections, and revenue assumptions;
(b) Direct the consultant to prepare and deliver a written report recommending specific rate adjustments or other corrective measures designed to restore Net Pledged Revenues to at least 1.40 times aggregate annual parity debt service in the following fiscal year; and
(c) Implement the consultant's recommendations, or demonstrate, to the reasonable satisfaction of the Trustee, that alternative measures proposed by CSIA will achieve the same result.
The consultant's covenant provides a structured cure pathway that prevents a temporary revenue shortfall from immediately escalating to a formal event of default. So long as CSIA engages the consultant, receives recommendations, and takes good-faith steps to implement those recommendations (or viable alternatives), the revenue shortfall is treated as a curable condition rather than a terminal breach. This mechanic is consistent with prevailing market practice for investment-grade municipal revenue bonds and was specifically identified by both LRG and PCA as a positive credit factor in their rating analyses.
It should be noted that the consultant's covenant is a process-oriented requirement — CSIA must retain the consultant and take corrective action, but the covenant does not require that the corrective action guarantee restoration of the 1.40x threshold. This is consistent with the rate-setting (rather than coverage) nature of the Rate Covenant: CSIA's obligation is to set rates at levels reasonably expected to produce the required coverage, and the consultant's role is to advise on the appropriate rate levels.
V. The Additional Bonds Test
A. Test Framework
The Bond Indenture permits CSIA to issue additional bonds on a parity basis with the Series 2023A Bonds and all other outstanding parity obligations ("Additional Bonds"), subject to compliance with the additional bonds test (the "Additional Bonds Test"). The Additional Bonds Test is designed to prevent CSIA from overleveraging its revenue base by requiring that existing or projected Net Pledged Revenues provide adequate coverage of debt service on all parity bonds, including the proposed additional issuance.
Under the Additional Bonds Test, CSIA may issue Additional Bonds provided that Net Pledged Revenues — measured either for the most recently completed fiscal year or, at CSIA's election, for the first full fiscal year during which the project funded by the proposed Additional Bonds is expected to be operational — are at least equal to 1.40 times maximum annual parity debt service ("MADS"), calculated to include the debt service on the proposed Additional Bonds.
The 1.40x threshold for the Additional Bonds Test is deliberately set equal to the Rate Covenant minimum. This design choice creates a unified standard: the same level of coverage that CSIA must maintain on an ongoing basis under the Rate Covenant is also the threshold that must be satisfied before new parity debt can be incurred. The alignment of these two thresholds ensures internal consistency in the covenant framework and avoids the anomaly that would arise if CSIA could issue Additional Bonds at a lower coverage threshold than it is required to maintain on an ongoing basis (or vice versa).
B. Election Between Historical and Projected Revenues
A significant feature of the Additional Bonds Test is CSIA's ability to elect between two methods of satisfying the coverage requirement:
(i) Historical Test. CSIA may satisfy the Additional Bonds Test using actual Net Pledged Revenues for the most recently completed fiscal year, as reflected in CSIA's audited financial statements. This test is straightforward and relies on verified historical data, providing a high degree of certainty to bondholders and rating agencies.
(ii) Projected Test. Alternatively, CSIA may elect to satisfy the Additional Bonds Test using estimated Net Pledged Revenues for the first full fiscal year during which the project funded by the proposed Additional Bonds is expected to be operational. The projected test is particularly useful when the project being financed is expected to generate incremental revenues (e.g., through the addition of new Participating Districts, expansion of system capacity, or implementation of rate adjustments) that would not be reflected in historical data.
The projected test requires certification by either an independent financial consultant meeting the qualification standards specified in the Bond Indenture or by CSIA's Chief Financial Officer (currently Denise R. Whitford). As discussed in Section IX.B below, underwriters' counsel at Alderman & Locke LLP has proposed a modification that would limit the projected-revenue election to certification by an independent consultant, excluding the CFO certification option. This proposed modification is an open negotiation item.
The projected test is particularly relevant for CSIA given the growth trajectory of the system's revenue base. As CSIA brings new capacity online — including the PSRAWTF being financed by the Series 2023A Bonds — the system's ability to generate revenues expands, and the projected test allows CSIA to capture this anticipated growth in the Additional Bonds Test calculation. Without the projected test option, CSIA would be limited to historical data that may not reflect the full revenue-generating potential of the expanded system, potentially constraining its ability to issue Additional Bonds for future capital projects.
C. Application to the Series 2023A Issuance
For the Series 2023A Bonds, CSIA has elected to satisfy the Additional Bonds Test using the historical test, based on audited FY 2022 financial data. The calculation is as follows:
Note: The figure of $278,400,000 represents total annual aggregate parity debt service. MADS may be slightly higher depending on amortization peaks across the various series of outstanding parity bonds. The precise MADS figure should be confirmed with Clearfield Municipal Advisors (Kenneth W. Barclay) based on the complete debt-service schedules for all outstanding parity series. If MADS differs from total annual aggregate parity debt service in a material respect, the coverage calculation should be adjusted accordingly. For purposes of this memorandum, we have used the $278,400,000 figure as a reasonable approximation.
Denise R. Whitford's CFO Certificate will certify compliance with the Additional Bonds Test as a closing deliverable on October 24, 2023. Calderwood & Harkness should review the form of the CFO Certificate to ensure that it accurately reflects the DSCR calculation and the election of the historical test methodology.
D. Implications for Future Issuances
CSIA's existing outstanding parity debt of $3,120,000,000 represents a significant and long-standing capital program. The Series 2023A Bonds increase total parity debt to $3,340,000,000. Given CSIA's ongoing capital improvement needs and the anticipated growth of the regional water treatment system, it is likely that CSIA will seek to issue Additional Bonds in the coming years. The capacity for such future issuances under the Additional Bonds Test is a significant consideration for CSIA's capital planning.
Capacity Under the Historical Test (FY 2022 Revenues). Using FY 2022 Net Pledged Revenues of $412,600,000, the maximum supportable MADS under the 1.40x Additional Bonds Test is:
$412,600,000 ÷ 1.40 = $294,714,286
Given current aggregate annual parity debt service of $278,400,000, the incremental annual debt-service capacity under the historical test is approximately:
$294,714,286 − $278,400,000 = $16,314,286
Capacity Under the Projected Test (FY 2024 Revenues). Using projected FY 2024 Net Pledged Revenues of $431,800,000, the maximum supportable MADS increases to:
$431,800,000 ÷ 1.40 = $308,428,571
The incremental annual debt-service capacity under the projected test would be approximately:
$308,428,571 − $278,400,000 = $30,028,571
These figures represent the maximum incremental annual debt service that CSIA could take on and still satisfy the Additional Bonds Test, without any revenue growth beyond the baseline used in each scenario. At a 3.25% coupon rate (consistent with the Series 2023A Bonds) and a 30-year amortization, incremental annual debt-service capacity of $16,314,286 would support approximately $275 million to $310 million of additional bond principal, and capacity of $30,028,571 would support approximately $510 million to $570 million of additional principal, depending on the amortization structure and coupon rate.
We recommend that Calderwood & Harkness counsel Clearfield Municipal Advisors (Kenneth W. Barclay, Principal) regarding the pacing of future capital issuances to preserve adequate covenant headroom. While the Additional Bonds Test provides a mechanical threshold, maintaining actual coverage well above the covenant floor is important for rating stability and investor confidence, as discussed in Section VIII below. A sustained decline in actual coverage toward the 1.40x floor could trigger negative rating actions even in the absence of a technical covenant breach.
VI. Flow of Funds and Application to Debt Service
A. Flow-of-Funds Waterfall
The Bond Indenture establishes a priority waterfall governing the application of Gross Pledged Revenues. Understanding the flow of funds is essential to evaluating the practical operation of the Rate Covenant, as the Rate Covenant functions as the enforcement mechanism ensuring that adequate revenues enter the top of the waterfall and flow through in sufficient quantities to satisfy each level of the priority structure.
The flow-of-funds waterfall under the Bond Indenture operates as follows, in descending order of priority:
1. Revenue Fund. All Gross Pledged Revenues are deposited into the Revenue Fund upon receipt. The Revenue Fund serves as the initial collection account and the entry point for all system revenues into the flow-of-funds waterfall.
2. Operation and Maintenance Fund ("O&M Fund"). From the Revenue Fund, amounts sufficient to pay current O&M Expenses are transferred to the O&M Fund. For FY 2022, O&M Expenses totaled $76,700,000. O&M Expenses are afforded the highest priority in the waterfall, reflecting the fundamental principle that the system must continue to operate in order to generate revenues to pay debt service.
3. Bond Fund (Debt Service Account). After satisfaction of O&M Expenses, amounts are transferred from the Revenue Fund to the Bond Fund in an amount sufficient to pay principal of and interest on all outstanding parity bonds as they come due. Interest payments on the Series 2023A Bonds are due semi-annually on April 1 and October 1 of each year, and principal payments are due annually. The Bond Fund transfer is the critical link between system revenues and bondholder payments.
4. Debt Service Reserve Fund ("DSRF"). To the extent that any draws have been made on the DSRF (or on the surety policy satisfying the DSRF requirement), amounts are transferred from the Revenue Fund to replenish the DSRF to its required level. For the Series 2023A Bonds, the DSRF requirement of $11,610,000 is satisfied by the surety policy from Olympia Guaranty Insurance Corp. (Policy No. OG-2023-MUN-4718). In the event that Olympia Guaranty is required to make a payment under the surety policy, CSIA must replenish the surety or replace it with a cash deposit or substitute surety.
5. Rebate Fund. Amounts due to the Internal Revenue Service under arbitrage rebate requirements (Internal Revenue Code § 148) are set aside in the Rebate Fund. Compliance with arbitrage rebate requirements is a condition to the maintenance of the tax-exempt status of the Series 2023A Bonds.
6. Subordinate Obligations / Surplus Fund. Any remaining Net Pledged Revenues, after satisfaction of all higher-priority transfers, may be applied to the payment of subordinate obligations (if any) or deposited into a surplus fund available for capital improvements, reserves, or other lawful purposes of CSIA.
B. Relationship Between Flow of Funds and Rate Covenant
The flow of funds and the Rate Covenant are complementary mechanisms that operate in tandem to protect bondholders. The flow-of-funds waterfall establishes the priority of claims on system revenues, ensuring that debt service is paid before subordinate obligations and surplus distributions. The Rate Covenant establishes the quantum of revenues that must be generated, ensuring that the waterfall is fully funded through at least the Bond Fund level, with adequate margin for contingencies.
The 1.40x coverage requirement is designed to provide a buffer above the 1.00x level (the bare minimum necessary to pay debt service on a dollar-for-dollar basis). This buffer serves multiple purposes:
(a) It absorbs variability in both revenues and O&M Expenses, providing a cushion against the risk that actual results in any given year may be less favorable than the prior year's experience;
(b) It ensures that the DSRF can be replenished if drawn upon, without jeopardizing current debt-service payments;
(c) It provides capacity for capital maintenance and renewal expenditures that, while excluded from the O&M Expense definition for coverage calculation purposes, must nonetheless be funded from system revenues; and
(d) It supports the system's credit profile, signaling to rating agencies and investors that CSIA generates revenues meaningfully in excess of its debt-service obligations.
The flow-of-funds waterfall is governed entirely by the Bond Indenture and operates automatically through the transfer mechanics specified therein. The Rate Covenant is the enforcement mechanism that ensures adequate revenues enter the top of the waterfall. If CSIA fails to set rates at levels sufficient to produce the required coverage, the waterfall will be underfunded, potentially resulting in insufficient transfers to the Bond Fund and, ultimately, a payment default on the parity bonds.
VII. Events of Default Related to Financial Covenants
A. Rate Covenant Default
A central feature of the Rate Covenant is the graduated approach to enforcement, which distinguishes between a temporary coverage shortfall and a sustained failure to take corrective action. A failure to comply with the Rate Covenant does not constitute an immediate event of default under the Bond Indenture, provided that CSIA takes the following corrective steps:
(a) Corrective Action Within 180 Days. CSIA must commence corrective action within 180 days of receiving notice of noncompliance (whether from the Trustee, a bondholder, or through CSIA's own annual compliance review process).
(b) Retention of Independent Consultant. CSIA must retain an independent financial consultant, meeting the qualification standards specified in the Bond Indenture, to review CSIA's rate structure and financial projections and to recommend specific rate adjustments or other corrective measures designed to restore coverage to at least 1.40x in the following fiscal year.
(c) Implementation of Recommendations. CSIA must implement the consultant's recommended rate adjustments or corrective measures, or demonstrate to the Trustee that alternative measures proposed by CSIA will achieve the same result, within the following fiscal year.
If CSIA fails to take the corrective steps described above, or if Net Pledged Revenues remain below 1.00x annual debt service for two consecutive fiscal years (indicating not merely a coverage shortfall but a potential inability to make current debt-service payments), an event of default may be declared by the Trustee (PNTC) upon the direction of holders of a majority in aggregate principal amount of outstanding parity bonds. The two-consecutive-year/1.00x threshold is a significant escalation trigger: it represents not merely a covenant breach but a threat to the system's ability to make debt-service payments as they come due.
B. Remedies Upon Default
The remedies available upon an event of default arising from a Rate Covenant violation differ significantly from those available in a corporate bond context. Under Washington municipal revenue bond law, acceleration is not available as a remedy for a rate-covenant default. This limitation reflects the public-purpose nature of the issuer and the essential-service character of the water treatment system — accelerating $3.34 billion of outstanding parity debt would serve no constructive purpose and would threaten the continued operation of critical public infrastructure.
The remedies available to the Trustee and bondholders in the event of a Rate Covenant default include:
(a) Mandamus Action. The Trustee or bondholders may seek a writ of mandamus from a Washington State court compelling CSIA to fix, charge, and collect rates at levels sufficient to produce the required coverage. Mandamus is a common remedy in the municipal bond context and has been upheld by Washington courts as an appropriate mechanism for enforcing rate covenants.
(b) Appointment of a Receiver. In extreme circumstances, a court may appoint a receiver to assume control of the system's rate-setting and financial management functions. Receivership is an extraordinary remedy that would be invoked only in the event of sustained noncompliance and demonstrated unwillingness or inability of CSIA's management to take corrective action.
(c) Injunctive Relief. The Trustee or bondholders may seek injunctive relief prohibiting CSIA from taking actions inconsistent with the Rate Covenant, such as reducing rates below the levels necessary to maintain the required coverage.
As a practical matter, the most likely enforcement path in the event of a Rate Covenant shortfall is the mandatory consultant mechanism described in Section IV.E above, followed by Trustee-directed correspondence and, if necessary, a mandamus action. The structured cure pathway and the cooperative relationship between CSIA and its bondholders are designed to resolve coverage shortfalls through administrative and financial corrective measures, rather than through adversarial litigation.
C. Cross-Default Considerations
An important structural consideration is the cross-default impact of a Rate Covenant violation. All outstanding parity bonds — including the existing $3,120,000,000 of parity debt and the Series 2023A Bonds — are issued under the same master Bond Indenture. The 1.40x Rate Covenant applies to aggregate annual parity debt service on all outstanding parity bonds, not to any individual series.
As a consequence, a Rate Covenant default is inherently a system-wide event: a failure to maintain 1.40x coverage on total parity debt service affects all holders of all outstanding parity series equally. There is no separate, series-specific rate covenant applicable only to the Series 2023A Bonds. This structure is typical of master-indenture revenue bond programs and reflects the pari passu nature of the pledge: all parity bondholders share equally in the security of the Net Pledged Revenues, and all are subject to the same covenant framework.
This cross-default structure means that the Trustee's enforcement authority — and the bondholder voting thresholds for directing Trustee action — are calculated across the entire $3,340,000,000 of outstanding parity bonds, not merely across the Series 2023A Bonds. A majority in aggregate principal amount of all outstanding parity bonds would need to direct the Trustee to declare an event of default, providing a significant threshold that prevents precipitous default declarations by a small number of bondholders.
VIII. Comparison to Market Standards and Rating Agency Expectations
A. Market Benchmarks for Municipal Water/Sewer Revenue Bonds
CSIA's 1.40x DSCR covenant is consistent with prevailing market standards for investment-grade water and sewer revenue bonds. Based on our review of comparable recent issuances and standard reference sources (including published rating criteria from LRG and PCA, as well as market surveys from Bond Buyer and municipal finance research firms), the typical DSCR covenant range for investment-grade municipal water and sewer revenue bonds is as follows:
CSIA's covenant level of 1.40x falls at the upper end of the range for "AA"/"AA−" rated issuers, reflecting the strong credit profile of the system and the expectation of robust coverage. CSIA's actual pro forma coverage of 1.48x (FY 2022) is within the expected range for an "AA"/"AA−" rated issuer, though it falls below the coverage levels typically seen for "AAA"/"AA+" credits. This is consistent with CSIA's underlying ratings of "AA" (LRG, stable) and "AA−" (PCA, stable).
B. Rating Agency Considerations
Both Lakeshore Ratings Group and Pinnacle Credit Analytics cited CSIA's strong coverage ratios and robust rate-setting authority as positive credit factors in their rating analyses. In particular:
• LRG ("AA" stable) noted that CSIA's actual coverage consistently exceeds the 1.40x covenant floor, that the take-or-pay wholesale rate structure provides revenue predictability, and that CSIA's unilateral rate-adjustment authority eliminates a key credit risk present in many municipal utility systems. LRG also noted the consultant's covenant backstop as a positive structural feature.
• PCA ("AA−" stable) highlighted CSIA's diversified service territory, the long-term nature of the Wholesale Water Treatment Services Agreements, and the de minimis incremental debt-service burden of the Series 2023A Bonds. PCA noted that CSIA's coverage, while adequate, is somewhat constrained by the size of the existing parity debt program relative to the revenue base, and that maintaining coverage meaningfully above the covenant floor is important for rating stability.
Both rating agencies emphasized that they evaluate not only the covenant floor (1.40x) but also the trajectory of actual and projected coverage. A sustained decline in actual coverage toward the covenant floor — even without a technical breach — could trigger negative outlook actions or, in an extreme scenario, a downgrade. Conversely, an improving coverage trend supports rating stability and creates the potential for positive rating actions over time.
CSIA should be mindful that future issuances of Additional Bonds will be evaluated by the rating agencies not only against the mechanical Additional Bonds Test but also in the context of the overall leverage profile and coverage trend. Issuing Additional Bonds at or near the 1.40x threshold — while technically permissible under the Bond Indenture — could be viewed negatively by the rating agencies if it results in a sustained erosion of actual coverage.
IX. Recommendations and Open Issues
A. Recommendations
Based on the analysis set forth in this memorandum, the following recommendations are made for George Trujillo's consideration:
1. CFO Certificate. Confirm that the CFO's Certificate, to be executed by Denise R. Whitford at or prior to closing, accurately reflects the pro forma DSCR of 1.48x on total annual aggregate parity debt service of $278,400,000, using FY 2022 audited Net Pledged Revenues of $412,600,000. The form of the CFO Certificate should be reviewed by Calderwood & Harkness to ensure that the mathematical calculation, the election of the historical test methodology, and the representations regarding compliance with the Additional Bonds Test are accurate and complete.
2. Definitional Consistency. Ensure that the Bond Indenture and First Supplemental Indenture consistently define "Net Pledged Revenues" to exclude depreciation, amortization, and capital outlay. Any inconsistency between the master indenture definition and the supplemental indenture definition could create ambiguity regarding the calculation of coverage ratios and should be resolved prior to closing. This review should also confirm that the definition is consistent with the methodology used by Hargrove & Associates CPAs, PLLC in preparing CSIA's audited financial statements.
3. Debt-Service Schedule Validation. Coordinate with Clearfield Municipal Advisors (Kenneth W. Barclay, Principal) to validate the debt-service schedules for all existing parity bonds and confirm that total annual aggregate parity debt service of $278,400,000 is accurate. Additionally, confirm the MADS figure for the entire parity bond program (inclusive of the Series 2023A Bonds), as the Additional Bonds Test is keyed to MADS rather than to average annual debt service. If MADS differs materially from $278,400,000, the coverage calculations in this memorandum should be updated accordingly.
4. Consultant's Covenant Language. Review the consultant's covenant language in the Bond Indenture to ensure that Clearfield Municipal Advisors LLC, or another qualified advisory firm, can serve in the backstop consultant role under the consultant's covenant. The qualification standards should be broad enough to ensure that CSIA can retain a qualified consultant promptly in the event of a coverage shortfall, without being limited to a single firm.
5. Co-Bond Counsel Coordination. Confirm with Pryor Crestfield LLP (Margaret S. Yoon and Elliot R. Stanton, co-bond counsel) that the Rate Covenant language is consistent with Washington statutory requirements under Chapter 43.160A RCW. In particular, confirm that CSIA's rate-setting authority as described in the Bond Indenture is consistent with the statutory framework and that the take-or-pay provisions in the Wholesale Water Treatment Services Agreements are enforceable under Washington law.
6. Continuing Disclosure. Address in the Continuing Disclosure Agreement — to be executed with PNTC as Dissemination Agent — that annual DSCR calculations will be included in CSIA's annual filings on the Electronic Municipal Market Access system ("EMMA") maintained by the Municipal Securities Rulemaking Board ("MSRB"), in accordance with Securities and Exchange Commission Rule 15c2-12. The annual DSCR disclosure should include actual Net Pledged Revenues, total annual aggregate parity debt service, the resulting DSCR, and a statement regarding compliance or noncompliance with the 1.40x Rate Covenant.
B. Open Issues for Discussion with Underwriters' Counsel
Two open negotiation items require George Trujillo's attention:
Additional Bonds Test — CFO Certification. Alderman & Locke LLP (Daniel F. Obermeyer and Christina M. Vega), counsel to the underwriting syndicate, has proposed certain modifications to the Additional Bonds Test language that would require the projected-revenue election to be certified exclusively by an independent financial consultant. Under this proposal, CSIA's CFO would not be permitted to certify projected revenues for purposes of the Additional Bonds Test; only an independent consultant could do so.
CSIA has historically relied on the CFO certification option as an efficient and cost-effective means of satisfying the projected test. Eliminating this option would require CSIA to retain and pay an independent consultant each time it wishes to use projected revenues for Additional Bonds Test compliance, adding cost and delay to the issuance process. We recommend discussing with George Trujillo whether CSIA should (a) accept the underwriters' counsel's proposed limitation; (b) reject it and insist on retaining the CFO certification option; or (c) propose a compromise, such as permitting CFO certification for issuances below a specified threshold (e.g., $100,000,000 aggregate principal amount) while requiring independent consultant certification for larger issuances.
Covenant Level. Confirm with Meridian Capital Partners LLC (Jonathan D. Kessler, Managing Director) that the 1.40x covenant level is acceptable to the underwriting syndicate and consistent with investor expectations for this credit tier. Based on our review of market standards (Section VIII.A above), 1.40x is at the upper end of the range for "AA"/"AA−" rated water and sewer revenue bonds. A higher covenant level (e.g., 1.50x) would provide greater bondholder protection but would constrain CSIA's operational and financial flexibility; a lower level (e.g., 1.25x) would provide less protection and could be viewed negatively by the rating agencies. We believe 1.40x represents an appropriate balance and expect it to be acceptable to the underwriting syndicate.
C. Post-Closing Monitoring
Following the closing of the Series 2023A Bonds, CSIA will be subject to ongoing compliance obligations under the Rate Covenant and the Bond Indenture. Calderwood & Harkness should advise CSIA's internal counsel, Martin J. Espinoza, regarding the establishment of a comprehensive compliance monitoring program, including the following elements:
(a) Annual DSCR Certification. CSIA must certify annually that Net Pledged Revenues satisfy the 1.40x Rate Covenant, based on audited financial statements for the most recently completed fiscal year.
(b) Surety Premium Payment. The annual surety premium payable to Olympia Guaranty Insurance Corp. ($23,220 per year) must be budgeted within O&M Expenses and paid when due. Failure to pay the surety premium could result in termination of the surety policy and a requirement to cash-fund the DSRF.
(c) Continuing Disclosure Filings. CSIA must make timely annual filings on EMMA, including audited financial statements and DSCR calculations, in accordance with the Continuing Disclosure Agreement and SEC Rule 15c2-12.
(d) Compliance Calendar. We recommend that CSIA's internal counsel implement a compliance calendar tracking all key dates, including Rate Covenant testing dates, continuing-disclosure filing deadlines, Additional Bonds Test certifications, surety premium payment dates, interest and principal payment dates, and optional redemption windows.
X. Conclusion
The financial covenant structure governing the Series 2023A Bonds — comprising the 1.40x Rate Covenant, the Additional Bonds Test, the consultant's covenant backstop, and the flow-of-funds waterfall — provides a robust and market-standard framework for bondholder protection while preserving CSIA's operational and financial flexibility.
CSIA's current DSCR of 1.48x (pro forma, FY 2022, on all parity debt including the Series 2023A Bonds) and projected FY 2024 coverage of approximately 1.55x demonstrate comfortable compliance with the 1.40x covenant minimum. The sensitivity analysis confirms that Net Pledged Revenues would need to decline by 5.5% from FY 2022 levels, or 9.7% from projected FY 2024 levels, before the covenant floor would be breached — thresholds that represent significant revenue disruptions well beyond normal variability.