CALDERWOOD & HARKNESS LLP 1420 Fifth Avenue, Suite 3600 Seattle, Washington 98101
Telephone: (206) 555-7800 Facsimile: (206) 555-7801
MEMORANDUM — PRIVILEGED AND CONFIDENTIAL ATTORNEY WORK PRODUCT
TO: George Trujillo, Partner; Patricia Dunmore, Partner
FROM: Michelle Tsao, Associate
DATE: May 31, 2023
RE: Negotiation Issues List and Commentary on Initial Term Sheet — Cascadia State Infrastructure Authority Water Treatment Revenue Bonds, Series 2023A (Tax-Exempt) — $220,000,000
MATTER NO.: 1030-00001
CLIENT: Cascadia State Infrastructure Authority ("CSIA")
Right-click to update Table of Contents
I. Introduction and Purpose
This memorandum sets forth Calderwood & Harkness LLP's ("C&H") issue-by-issue analysis and commentary on the Initial Term Sheet (the "Term Sheet") circulated on May 22, 2023, by Meridian Capital Partners LLC (the "Senior Managing Underwriter"), through its counsel, Alderman & Locke LLP (Daniel F. Obermeyer, Partner; Christina M. Vega, Associate), for the proposed $220,000,000 Cascadia State Infrastructure Authority Water Treatment Revenue Bonds, Series 2023A (Tax-Exempt) (the "Bonds" or the "Series 2023A Bonds").
C&H represents the Cascadia State Infrastructure Authority ("CSIA") as issuer's counsel in connection with the proposed issuance of the Bonds. Pryor Crestfield LLP (Margaret S. Yoon, Partner; Elliot R. Stanton, Of Counsel) serves as co-Bond Counsel and will render the approving legal opinion and the tax opinion at closing. C&H's engagement encompasses issuer's counsel services, including the preparation and negotiation of all transaction documents, rendering of the issuer's counsel opinion, and delivery of the 10b-5 negative assurance letter in connection with the Official Statement.
The purpose of this memorandum is to identify: (a) terms in the Initial Term Sheet that are acceptable to CSIA and may be confirmed as agreed; (b) terms requiring modification, clarification, or additional documentation before CSIA can accept them; and (c) C&H's recommended counter-positions on behalf of CSIA, developed in consultation with CSIA management and CSIA's municipal advisor. Input from George Trujillo, as relationship partner for the CSIA engagement, has been incorporated throughout this memorandum.
The Term Sheet was circulated by Meridian Capital Partners LLC (Jonathan D. Kessler, Managing Director, Public Finance) and reflects Meridian's initial proposed terms for the negotiated sale of the Bonds. Dralvecen Fenn & Co., Inc. (Sarah E. Mulvaney, Director, Municipal Finance) serves as co-managing underwriter and is expected to participate in the syndicate on the allocation basis described in the Term Sheet. Alderman & Locke LLP serves as underwriters' counsel and will render the underwriters' counsel opinion at closing.
The issuance of the Bonds was authorized by CSIA Board Resolution No. 2023-014, adopted on May 9, 2023, which authorized the issuance of revenue bonds in an aggregate principal amount not to exceed $250,000,000 and delegated negotiation authority over the final terms and conditions of the Bonds to Executive Director Harold K. Nakamura and Chief Financial Officer Denise R. Whitford, acting jointly or severally. The Board Resolution further authorized the execution and delivery of the Bond Indenture, Revenue Pledge Agreement, Bond Purchase Agreement, Continuing Disclosure Undertaking, Tax Regulatory Agreement, and all related documents and certificates necessary to effectuate the issuance, sale, and delivery of the Bonds.
Clearfield Municipal Advisors LLC (Kenneth W. Barclay, Principal), CSIA's SEC-registered municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act and MSRB Rule G-42, has been consulted on all pricing and financial terms discussed in this memorandum. Clearfield's independent assessment of market conditions, comparable transactions, and the reasonableness of Meridian's proposed pricing and structural terms has informed the analysis set forth below.
This memorandum is intended to serve as the basis for a formal written response to Meridian Capital Partners and Alderman & Locke, reflecting CSIA's consolidated positions on the Term Sheet. It is also intended to guide the negotiation sessions expected to take place in June and early July 2023, in advance of the anticipated distribution of the Preliminary Official Statement on June 26, 2023.
II. Summary of Key Negotiation Issues
The following table provides a concise overview of the principal issues addressed in this memorandum, together with the current status of each issue. Issues flagged as "Open" or "CSIA Counter-Position Recommended" are discussed in detail in Section III below.
As reflected above, the three principal areas of substantive disagreement requiring focused negotiation are: (1) the financial covenant levels (DSCR, additional bonds test, and rate covenant), where CSIA's position is firm at 1.40x; (2) the underwriters' discount, where CSIA seeks a reduction from 0.45% to 0.40%; and (3) the debt-service reserve fund funding mechanism, where CSIA proposes surety bond satisfaction in lieu of cash funding.
III. Detailed Issue-by-Issue Commentary
III.A. Bond Title and Series Designation
Meridian Proposal: "Cascadia State Infrastructure Authority Water Treatment Revenue Bonds, Series 2023A (Tax-Exempt)"
C&H Commentary: The proposed bond title and series designation are acceptable. The title accurately reflects the nature of the obligations as revenue bonds of CSIA, secured by water treatment revenues, and the "(Tax-Exempt)" designation is appropriate given the anticipated compliance with Section 103 of the Internal Revenue Code of 1986, as amended (the "Code"). The title is consistent with the authorization contained in CSIA Board Resolution No. 2023-014 and the issuing authority conferred upon CSIA by its enabling statute, Chapter 43.160A of the Revised Code of Washington ("RCW").
Leonard Cross, C&H's tax specialist assigned to this matter, has confirmed that the tax-exempt designation is appropriate based on the current structure of the transaction, including the governmental purpose of the Puget Sound Regional Advanced Water Treatment Facility (the "PSRAWTF" or the "Project"), the absence of private business use or private security exceeding the de minimis thresholds under Code Sections 141(b) and (c), and the anticipated compliance with the arbitrage and rebate requirements of Code Section 148. The final determination of tax-exempt status will be set forth in the Tax Opinion to be delivered by Pryor Crestfield LLP at closing.
The "Series 2023A" designation is appropriate as the first series of bonds to be issued by CSIA under a new Bond Indenture in calendar year 2023. CSIA has not issued any other series of bonds under a 2023-dated indenture.
Status: Agreed.
III.B. Aggregate Principal Amount
Meridian Proposal: $220,000,000
C&H Commentary: The proposed aggregate principal amount of $220,000,000 is acceptable. Clearfield Municipal Advisors has confirmed that this amount is consistent with CSIA's financing needs for the Puget Sound Regional Advanced Water Treatment Facility. The sizing analysis is summarized as follows:
The total estimated project cost of the PSRAWTF is $237,400,000. This amount encompasses the design-build construction contract with Northtide Environmental Engineering, Inc. (Garrett L. Henriksen, CEO) under GMP Contract No. CSIA-DB-2023-001, which establishes a guaranteed maximum price of $193,500,000, together with owner-managed costs including land acquisition, environmental mitigation, permitting, project management, owner's contingency, and equipment procurement not included in the GMP contract. CSIA will contribute $17,400,000 from its capital reserves as an equity contribution to the project, reducing the bond-financed portion to approximately $220,000,000.
The net bond proceeds available for deposit to the Project Fund, after accounting for the original issue discount, underwriters' discount, and costs of issuance (including capitalized interest), are estimated at $215,490,000. The derivation of this figure is as follows:
Par Amount: $220,000,000
Less: Original Issue discount (0.75% of par): ($1,650,000)
Less: Underwriters' discount (0.45% of par): ($990,000)
Net Bond Proceeds: $217,360,000
Less: Costs of Issuance (excluding capitalized interest): ($1,870,000)
Net Proceeds Available for Project Fund and Capitalized Interest: $215,490,000
The capitalized interest fund of $4,510,000 is separately identified within the cost of issuance allocation and will be deposited to a Capitalized Interest Account within the Bond Fund. The remaining net proceeds of approximately $210,980,000 will be deposited to the Project Fund for construction disbursements.
When combined with CSIA's equity contribution of $17,400,000 and the $4,510,000 in capitalized interest, total available funds for the project and debt service during the construction period are $232,890,000. This is sufficient to cover the total project cost of $237,400,000 when combined with investment earnings on the Project Fund during the construction period, which are estimated by Clearfield at approximately $4,500,000 to $5,200,000 based on current short-term investment rates.
The $220,000,000 par amount is within the $250,000,000 maximum authorized by Board Resolution No. 2023-014.
Status: Agreed.
III.C. Interest Rate
Meridian Proposal: Fixed coupon rate of 3.25% per annum (325 basis points).
C&H Commentary: C&H recommends preliminary acceptance of the proposed 3.25% fixed coupon rate, subject to market conditions at the time of pricing and execution of the Bond Purchase Agreement. The fixed rate assumption is fundamental to the transaction structure and has been used by Leonard Cross in preparing the Tax Regulatory Agreement analysis, including the arbitrage yield calculation under Code Section 148 and Treasury Regulation Section 1.148-4.
At a 3.25% coupon on $220,000,000 of outstanding principal, annual interest expense in Year 1 of the Bonds is $7,150,000 ($220,000,000 × 0.0325). Based on a level-debt-service amortization structure over the 30-year term, approximate annual aggregate debt service (principal and interest) is estimated at $11,610,000. This figure is subject to refinement based on the final amortization schedule to be included in the Bond Indenture.
Clearfield Municipal Advisors has advised that the 3.25% coupon is within the range of current market rates for investment-grade, tax-exempt municipal revenue bonds in the water and sewer sector with a 30-year maturity. However, municipal market conditions remain subject to volatility, and Clearfield has noted that the MMD AAA benchmark yield for 30-year maturities has fluctuated between 3.05% and 3.40% during the month of May 2023. The credit spread applicable to CSIA's AA/AA− rated bonds would be expected to add 15 to 25 basis points to the benchmark yield, suggesting a fair market coupon in the range of 3.20% to 3.65% as of the date of this memorandum.
C&H recommends that the Bond Purchase Agreement include a pricing confirmation mechanism providing that if market conditions shift materially between the distribution of the Preliminary Official Statement (targeted for June 26, 2023) and the execution of the Bond Purchase Agreement (anticipated for August 30, 2023), the parties will negotiate in good faith to adjust the coupon rate or OID pricing to reflect prevailing market conditions. This mechanism should be mutual — protecting both CSIA from above-market pricing and the underwriters from below-market pricing — and should reference an agreed benchmark, such as the Ostrander Health IT AAA General Obligation index, as the measuring standard.
Status: Agreed in principle, subject to market verification at signing (anticipated August 30, 2023).
III.D. Maturity Date
Meridian Proposal: October 1, 2053 (30-year final maturity from the dated date of the Bonds).
C&H Commentary: The proposed 30-year final maturity date of October 1, 2053 is acceptable. A 30-year maturity is standard for large-scale infrastructure revenue bond financings and is consistent with CSIA's capital planning assumptions. The useful life of the PSRAWTF facility, based on the engineering assessment prepared by Northtide Environmental Engineering, Inc. in connection with GMP Contract No. CSIA-DB-2023-001, is estimated at 50 years with proper maintenance, well in excess of the 30-year bond term.
Chapter 43.160A RCW permits CSIA to issue revenue bonds with maturities of up to 40 years from the date of issuance. The proposed 30-year final maturity is comfortably within this statutory maximum. Additionally, the 30-year maturity is consistent with the maturity profile of CSIA's existing outstanding parity revenue bonds, which have final maturities ranging from 2035 to 2052, thereby avoiding a concentration of maturities in any single year that could create refinancing risk.
The amortization schedule for the Bonds has not yet been finalized. C&H anticipates that the Bond Indenture will include mandatory sinking fund installments in the final years of the amortization period, and CSIA should ensure that the sinking fund installment schedule is structured to produce approximately level annual debt service over the 30-year term.
Status: Agreed.
III.E. Dated Date / Closing Date
Meridian Proposal: Original target closing date of October 15, 2023, with the dated date implied to be the same.
C&H Commentary: CSIA should request flexibility to adjust the dated date to align with the actual date of delivery of the Bonds, rather than a fixed date established in advance. If closing is delayed beyond October 15, 2023 — whether due to market conditions, documentation delays, or other factors — CSIA should not bear the cost of additional interest accrual from an artificially early dated date. Interest on the Bonds begins to accrue from the dated date, and any gap between the dated date and the actual delivery date would result in interest expense for which CSIA receives no corresponding benefit, as the Bond proceeds would not be available for investment or disbursement until delivery.
This concern proved to be well-founded in the actual course of the transaction: the Tax Regulatory Agreement was executed on October 15, 2023 (the original target date), while the Bond Indenture, Revenue Pledge Agreement, and bond delivery occurred on October 24, 2023, a delay of nine calendar days. At a 3.25% coupon on $220,000,000 of par, each day of accrual represents approximately $19,589 in interest ($7,150,000 ÷ 365), and a nine-day gap would have resulted in approximately $176,301 of interest expense accruing before CSIA received the bond proceeds.
C&H recommends that the Term Sheet be revised to state: "Dated Date: The date of delivery of the Bonds." This is a standard formulation in negotiated municipal bond transactions and should not be controversial.
If the dated date is set as the delivery date, the first interest payment date of April 1, 2024 would represent a short first coupon period (from approximately late October 2023 to April 1, 2024, or approximately 159 days on a 30/360 basis), which is standard and administrable. The first coupon payment would be calculated on the basis of accrued interest from the dated date to April 1, 2024, at the stated coupon rate.
CSIA Counter-Position: Dated date to equal the actual date of delivery of the Bonds.
Status: Open — CSIA Counter-Position to make dated date equal to actual delivery date.
III.F. Interest Payment Dates
Meridian Proposal: April 1 and October 1 of each year, commencing April 1, 2024.
C&H Commentary: The proposed semi-annual interest payment schedule is acceptable and standard for municipal revenue bond transactions. The April 1 and October 1 payment dates align with CSIA's existing debt-service payment schedule on its outstanding parity revenue bonds, which simplifies cash management and fund administration.
C&H has confirmed with Pacific Northwest Trust Company, N.A. ("PNTC") (Alan M. Greer, Vice President, Corporate Trust Services), which will serve as Trustee and Paying Agent under the Bond Indenture, that this payment schedule is fully administrable within PNTC's systems and is consistent with standard DTC payment processing timelines. PNTC will require debt-service funds to be on deposit in the Bond Fund no later than five business days prior to each payment date to ensure timely distribution through DTC to beneficial owners.
Status: Agreed.
III.G. Optional Redemption / Call Protection
Meridian Proposal: The Bonds are callable at par (100%) on any date on or after October 1, 2033, representing a 10-year call protection period from the anticipated dated date.
C&H Commentary: Meridian's initial proposal provides for a 10-year non-call period, after which the Bonds are callable at par without premium. CSIA's initial preference, as communicated by Chief Financial Officer Denise R. Whitford and confirmed by Clearfield Municipal Advisors, was for an 8-year call protection period, which would make the Bonds callable at par on or after October 1, 2031. The rationale for CSIA's initial preference was to preserve maximum flexibility for potential advance refunding or current refunding of the Bonds if interest rates decline during the first decade of the bond term.
However, Clearfield has acknowledged that a 10-year par call is market standard for tax-exempt municipal revenue bonds and that a shorter call protection period could result in one or more of the following adverse consequences: (i) a wider coupon, as investors compensated for shortened call protection would demand a higher yield; (ii) reduced investor demand during the marketing period, potentially impairing the ability of the underwriters to distribute the Bonds at the proposed offering price; or (iii) a wider OID, further reducing net proceeds to CSIA.
Following discussions with George Trujillo and Clearfield, C&H recommends the following approach:
CSIA Counter-Position: CSIA will accept the 10-year call protection period (Bonds callable at par on or after October 1, 2033) provided that the interest rate and OID pricing remain as proposed in the Term Sheet (i.e., 3.25% coupon and 99.25% OID). If, at any point during the negotiation or pricing process, Meridian seeks to increase the coupon above 3.25% or widen the OID below 99.25%, CSIA reserves the right to revisit the call protection term and request a shorter call protection period as a corresponding concession.
The Bonds should not be subject to any make-whole redemption provision or declining premium redemption schedule. Par call at 100% on or after October 1, 2033 should be the only optional redemption mechanism. Extraordinary redemption provisions (for events such as condemnation of the Project or unexpended proceeds) will be addressed separately in the Bond Indenture.
C&H notes that the optional redemption date has implications for the yield calculation under Code Section 149(d) (relating to advance refunding limitations) and the arbitrage yield calculation under Code Section 148. Leonard Cross will address these implications in the Tax Memorandum currently under preparation. In particular, the optional redemption date is relevant to the determination of the "yield to call" on the Bonds for purposes of establishing the arbitrage yield under Treasury Regulation Section 1.148-4(b)(3).
Status: Agreed at 10-year par call (October 1, 2033), subject to pricing package remaining intact. No make-whole or premium redemption.
III.H. Original Issue discount (OID) Pricing
Meridian Proposal: The Bonds are to be priced at 99.25% of par, representing an original issue discount of 0.75%, or $1,650,000 on $220,000,000 of aggregate par amount ($220,000,000 × 0.0075 = $1,650,000).
C&H Commentary: The OID directly reduces net proceeds available to CSIA. The dollar impact of the OID is as follows:
Par Amount: $220,000,000
Public Offering Price (99.25% of par): $218,350,000
OID: $1,650,000
Net Proceeds before Underwriters' discount: $218,350,000
Less Underwriters' discount: ($990,000)
Net Proceeds to CSIA: $217,360,000
The $1,650,000 OID represents funds that do not flow through to the Project Fund and are effectively retained by bondholders as additional yield. From CSIA's perspective, the OID functions as a cost of the financing — the Bonds bear a face amount of $220,000,000 (and CSIA will pay debt service on the full $220,000,000 par amount), but only $218,350,000 is received by CSIA at closing (before the underwriters' discount).
Clearfield Municipal Advisors has confirmed that a public offering price of 99.25% (OID of 0.75%) is within the range of recent comparable tax-exempt revenue bond pricings in the Pacific Northwest market and is consistent with the current yield curve for AA-rated municipal revenue bonds with a 30-year maturity and 10-year par call. Clearfield has noted, however, that the OID environment is dynamic, and that some comparable transactions have been priced at par or at shallower discounts (99.50%–100.00%).
C&H recommends acceptance of the 99.25% OID, subject to the understanding that if the OID widens beyond 99.00% at any point during the pricing process, CSIA and Clearfield should evaluate whether the aggregate par amount of the Bonds needs to be increased to maintain adequate net proceeds for deposit to the Project Fund. A widening of the OID from 99.25% to 99.00% would reduce net proceeds by an additional $550,000 ($220,000,000 × 0.0025), which could create a shortfall in the Project Fund absent an increase in the par amount or a corresponding reduction in project scope.
From a tax perspective, the OID on the Bonds is treated as tax-exempt interest to bondholders under Code Section 1288, accreted on a constant-yield basis over the life of the Bonds. The OID does not affect the tax-exempt status of the Bonds themselves but is relevant to the determination of the "issue price" of the Bonds under Treasury Regulation Section 1.148-1(f) for arbitrage yield calculation purposes.
Status: Agreed at 99.25%, subject to no further widening below 99.00%.
III.I. Underwriters' discount
Meridian Proposal: An underwriters' discount of 0.45% of the aggregate par amount of the Bonds, equal to $990,000 ($220,000,000 × 0.0045). The discount is to be allocated between the underwriters as follows:
Meridian Capital Partners LLC (Senior Managing Underwriter) — 70%: $693,000
Dralvecen Fenn & Co., Inc. (Co-Managing Underwriter) — 30%: $297,000
C&H Commentary: CSIA and Clearfield Municipal Advisors believe that the proposed underwriters' discount of 0.45% is at the upper end of the market range for a negotiated sale of investment-grade municipal revenue bonds of this size and credit quality. Clearfield has surveyed recent comparable issuances in the Pacific Northwest municipal market and has identified a range of underwriters' discounts from 0.35% to 0.42% for transactions of broadly similar characteristics (i.e., investment-grade, tax-exempt revenue bonds in the $100 million to $350 million par amount range, with AA-category credit ratings). A summary of comparable transactions is attached as Appendix B to this memorandum.
The difference between 0.45% and CSIA's proposed 0.40% discount is $110,000 ($220,000,000 × 0.0005). While this amount is modest in the context of a $220,000,000 financing, it represents $110,000 in additional net proceeds that would be available for deposit to the Project Fund, reducing the potential for cost overruns or the need for supplemental equity contributions from CSIA.
CSIA Counter-Position: CSIA proposes an underwriters' discount of 0.40% of the aggregate par amount of the Bonds, equal to $880,000 ($220,000,000 × 0.0040). This represents a reduction of $110,000 from Meridian's proposal and would result in the following allocation (assuming the 70/30 split is maintained):
Meridian Capital Partners LLC — 70%: $616,000
Dralvecen Fenn & Co., Inc. — 30%: $264,000
Fallback Position: If Meridian insists on the 0.45% discount and will not agree to a reduction, CSIA may accept the 0.45% discount provided that Meridian agrees to assume certain additional closing expenses that are typically allocated to the issuer under the standard cost-of-issuance allocation. Specifically, CSIA would request that the underwriters bear the following costs, which would otherwise be charged against the costs-of-issuance fund:
(a) CUSIP assignment fees (Standard & Poor's CUSIP Service Bureau): estimated at $1,000–$1,500;
(b) DTC processing and eligibility fees: estimated at $5,000–$8,000;
(c) MSRB underwriting assessment: estimated at $1,500;
(d) Printing and distribution of the Official Statement (final bound copies): estimated at $15,000–$20,000.
In aggregate, the expense shift would offset approximately $22,500–$31,000 of the $110,000 difference, partially bridging the gap between CSIA's target and Meridian's proposal.
The allocation of the underwriters' discount between Meridian Capital Partners (70%) and Dralvecen Fenn & Co. (30%) is a matter between the underwriters pursuant to their Agreement Among Underwriters and is not a matter on which CSIA takes a position.
Status: Open — CSIA Counter-Position of 0.40% ($880,000); fallback to 0.45% with expense allocation shift.
III.J. Denomination and Form
Meridian Proposal: The Bonds are to be issued in authorized denominations of $5,000 or any integral multiple thereof. The Bonds will be issued in book-entry-only form through The Depository Trust Company ("DTC"), with Cede & Co., as nominee of DTC, as the sole registered owner of the Bonds.
C&H Commentary: The proposed denomination and form are standard for municipal bond transactions and are acceptable. The $5,000 minimum denomination is required by MSRB Rule G-15 for municipal securities and is consistent with market convention. Book-entry-only issuance through DTC is the standard delivery mechanism for publicly offered municipal bonds and eliminates the need for physical bond certificates.
PNTC's DTC Participant Number is 2741. PNTC has confirmed its participation in DTC's Fast Automated Securities Transfer ("FAST") program, which will facilitate the delivery of the Bonds at closing.
The DTC Letter of Representations (sometimes referred to as the DTC Blanket Issuer Letter of Representations) between CSIA and DTC, a standard DTC form, will be executed prior to or at closing. C&H will circulate the DTC Letter of Representations as part of the closing document package.
Status: Agreed.
III.K. CUSIP
Meridian Proposal: CUSIP Base Number 148392, as assigned by CUSIP Global Services (operated by Drayton Services Inc.).
C&H Commentary: The CUSIP Base Number has been confirmed as correctly assigned. Individual CUSIP numbers for each maturity of the Bonds will be assigned during the pricing process and will be included in the Official Statement. C&H notes that CUSIP numbers are assigned for convenience of reference only and are not intended to imply any opinion as to the validity or tax-exempt status of the Bonds.
Status: Agreed.
III.L. Debt-Service Coverage Ratio (DSCR) Covenant
Meridian Proposal: CSIA is to covenant to maintain net pledged revenues in each fiscal year in an amount equal to not less than 1.50 times (1.50x) the annual aggregate parity debt service for such fiscal year.
C&H Commentary: CSIA strongly objects to the proposed 1.50x DSCR covenant. This is one of the most consequential terms in the Term Sheet and represents the most significant area of disagreement between CSIA and Meridian. The objection is based on the following analysis:
Parity Debt and Debt-Service Calculations. CSIA's existing outstanding parity revenue bonds total $3,120,000,000 in aggregate principal amount. These bonds were issued under multiple prior bond indentures and supplemental indentures, all of which contain a uniform DSCR rate covenant of 1.40x. The addition of the Series 2023A Bonds at $220,000,000 of par will bring total outstanding parity debt to $3,340,000,000. Total annual aggregate parity debt service (including the Series 2023A Bonds) is estimated at $278,400,000.
Pro Forma DSCR Analysis. CSIA's audited financial statements for fiscal year 2022 (year ended June 30, 2022, audited by Hargrove & Associates CPAs, PLLC) report the following:
Gross Pledged Revenues (FY 2022): $489,300,000
Less: Operation and Maintenance Expenses (FY 2022): ($76,700,000)
Net Pledged Revenues (FY 2022): $412,600,000
The pro forma DSCR based on FY 2022 actual net pledged revenues and projected aggregate parity debt service (including the Series 2023A Bonds) is:
DSCR = Net Pledged Revenues ÷ Aggregate Annual Parity Debt Service
DSCR = $412,600,000 ÷ $278,400,000 = 1.48x
A 1.50x DSCR covenant would mean that CSIA is in immediate technical non-compliance upon issuance of the Series 2023A Bonds. The FY 2022 actual DSCR of 1.48x falls below the proposed 1.50x threshold by two basis points. While this shortfall may appear narrow, technical non-compliance would constitute a breach of the rate covenant under the Bond Indenture and could trigger notice requirements to the Trustee, remedial action obligations, potential acceleration events (depending on cure provisions), and adverse credit surveillance actions by Lakeshore Ratings Group and Pinnacle Credit Analytics.
Projected DSCR. CSIA's budget projections for fiscal year 2024 (the first full fiscal year after anticipated bond issuance) estimate net pledged revenues of $431,800,000. This would produce a projected pro forma DSCR of approximately 1.55x ($431,800,000 ÷ $278,400,000), which exceeds the proposed 1.50x threshold. However, reliance on budget projections rather than actual audited results for purposes of establishing initial covenant compliance is imprudent and exposes CSIA to the risk that actual revenues may fall short of projections due to factors beyond CSIA's control, including drought conditions affecting water demand, regulatory changes, or economic downturns affecting connection fee revenue.
Consistency with Existing Parity Indentures. All of CSIA's existing outstanding parity revenue bonds — totaling $3,120,000,000 — are governed by indentures containing a 1.40x DSCR rate covenant. Imposing a 1.50x covenant on the Series 2023A Bonds alone, or amending the existing parity framework to 1.50x, would create one of the following unacceptable outcomes:
(a) If the 1.50x covenant applies only to the Series 2023A Bonds, CSIA would be subject to two different DSCR covenant levels across its parity debt — 1.40x for existing bonds and 1.50x for the Series 2023A Bonds — creating administrative complexity and the potential for the Series 2023A Bonds to be in technical default while existing parity bonds are in compliance;
(b) If the 1.50x covenant is intended to apply across the entire parity lien (as appears to be Meridian's intention), this would require amendments to all existing parity bond indentures — a process that would require the consent of holders of a majority in principal amount of each series of outstanding parity bonds, which is impractical in the timeframe of this transaction and, in C&H's judgment, unlikely to succeed; or
(c) A 1.50x covenant could trigger cross-default provisions in existing parity bond indentures if those indentures contain provisions treating a default under any parity obligation as a default under all parity obligations.
Impact on CSIA Operations. The 14 participating municipal water and sewer districts that receive wholesale water treatment services from CSIA are the primary source of pledged revenues. CSIA's rate-setting authority is governed by the Wholesale Water Treatment Services Agreements with these districts. A 1.50x rate covenant would constrain CSIA's discretion in setting wholesale rates and could require rate increases that are disproportionate to the incremental debt service attributable to the Series 2023A Bonds, creating political and operational difficulties.
Rating Agency Context. CSIA's credit ratings — AA (stable outlook) from Lakeshore Ratings Group and AA− (stable outlook) from Pinnacle Credit Analytics — were assigned based on the existing 1.40x covenant framework, CSIA's strong historical DSCR performance (averaging 1.52x over the past five fiscal years), and the diversity and stability of the revenue base. There is no indication from either rating agency that a higher covenant level is necessary to support the current ratings.
CSIA Counter-Position: The DSCR rate covenant in the Bond Indenture must be set at 1.40x of annual aggregate parity debt service, consistent with all existing parity bond indentures. CSIA will not agree to a 1.50x covenant under any circumstances. This position is non-negotiable.
Status: Open — CSIA strongly insists on 1.40x. Non-negotiable.
III.M. Additional Bonds Test
Meridian Proposal: As a condition to the issuance of additional parity bonds, net pledged revenues for the most recently completed fiscal year must equal at least 1.50 times (1.50x) maximum annual debt service on all parity bonds, including the proposed additional bonds.
C&H Commentary: CSIA's objection to the 1.50x multiplier applies with equal force to the additional bonds test. The rationale is the same as set forth in Section III.L above — the multiplier must be 1.40x, not 1.50x, for consistency with existing parity indentures, practical compliance, and operational flexibility.
In addition to the multiplier issue, C&H identifies a structural concern with Meridian's proposed formulation of the additional bonds test. Meridian proposes that the test be based solely on net pledged revenues "for the most recently completed fiscal year." CSIA's existing parity indentures include an election mechanism that permits CSIA to satisfy the additional bonds test using either (a) actual net pledged revenues for the most recently completed fiscal year, or (b) estimated net pledged revenues for the first full fiscal year after completion of the project to be financed by the proposed additional bonds, as certified by CSIA's consulting engineer. This election mechanism is critically important to CSIA's ability to finance future capital improvements.
The rationale for the election mechanism is straightforward: when CSIA constructs a new water treatment facility or expands existing capacity, the revenue generated by the new or expanded facility will not be reflected in the most recently completed fiscal year's financial results (because the facility has not yet been placed in service). An additional bonds test based solely on historical revenues would therefore fail to account for the incremental revenue attributable to the new facility, potentially preventing CSIA from financing necessary infrastructure improvements even when the improvements themselves will generate sufficient revenue to support the additional debt.
CSIA Counter-Position: The additional bonds test in the Bond Indenture must be set at 1.40x of maximum annual parity debt service, calculated using either (i) actual net pledged revenues for the most recently completed fiscal year, or (ii) at CSIA's election, estimated net pledged revenues for the first full fiscal year after the completion of the project to be financed by the proposed additional bonds, as certified by an independent consulting engineer engaged by CSIA. This position is non-negotiable and is consistent with the terms of all existing parity bond indentures.
C&H further notes the interaction between the additional bonds test and the rate covenant: if the additional bonds test multiplier exceeds the rate covenant multiplier, CSIA could find itself in the paradoxical situation where it is in compliance with the rate covenant (because actual DSCRs exceed 1.40x) but unable to issue additional bonds (because actual DSCRs are below 1.50x). This asymmetry would constrain CSIA's capital investment flexibility without a corresponding benefit to bondholders, who are already protected by the rate covenant.
Status: Open — CSIA Counter-Position of 1.40x with fiscal year election. Non-negotiable.
III.N. Rate Covenant
Meridian Proposal: CSIA is to covenant to set rates and charges sufficient to produce net pledged revenues in each fiscal year equal to at least the DSCR covenant level — proposed by Meridian at 1.50x — of annual aggregate parity debt service.
C&H Commentary: The rate covenant level is directly linked to the DSCR covenant discussion set forth in Section III.L above. If the DSCR covenant is settled at 1.40x (as CSIA insists), the rate covenant automatically becomes an obligation to set rates sufficient to produce net pledged revenues equal to at least 1.40x of annual aggregate parity debt service.
Beyond the multiplier issue, C&H offers the following additional commentary on the rate covenant structure:
Rate-Setting Authority. CSIA's rate-setting authority derives from the Wholesale Water Treatment Services Agreements (the "Service Agreements") with the 14 participating municipal water and sewer districts. Under the Service Agreements, CSIA has full discretion to establish and adjust wholesale water treatment service charges, connection fees, and related charges, subject only to the requirement that charges be established on a cost-of-service basis and that CSIA provide 120 days' advance written notice of rate adjustments. The rate covenant should be drafted in a manner that acknowledges this existing contractual framework and does not impose constraints inconsistent with the terms of the Service Agreements.
Cure Period. C&H recommends the inclusion of a cure period of 180 days following the determination that CSIA has failed to meet the rate covenant. During the cure period, CSIA would be permitted to implement rate adjustments (including emergency rate adjustments under the terms of the Service Agreements) to restore compliance with the rate covenant, without the failure constituting an event of default under the Bond Indenture. The 180-day cure period is consistent with the notice and implementation requirements of the Service Agreements (120 days' advance notice plus 60 days for implementation) and provides CSIA with a reasonable opportunity to cure a rate covenant shortfall through the normal rate-setting process, rather than forcing immediate default.
Calculation Methodology. The rate covenant should specify that "net pledged revenues" means gross pledged revenues less operation and maintenance expenses, and should exclude depreciation, amortization, and non-cash charges from the calculation. Capital expenditures should also be excluded, consistent with standard municipal revenue bond practice. The definition of "operation and maintenance expenses" should be consistent with the definition used in CSIA's existing parity bond indentures.
CSIA Counter-Position: Rate covenant at 1.40x, with a 180-day cure period for covenant violations, consistent with CSIA's existing contractual framework for rate adjustments.
Status: Open — tied to DSCR covenant resolution; CSIA requires 1.40x with 180-day cure period.
III.O. Debt-Service Reserve Fund / Surety Structure
Meridian Proposal: The Bond Indenture will require the establishment of a debt-service reserve fund (the "DSRF") funded to the least of:
(i) Maximum annual debt service on the Series 2023A Bonds;
(ii) 125% of average annual debt service on the Series 2023A Bonds; or
(iii) 10% of the original aggregate par amount of the Series 2023A Bonds.
Meridian proposes that the DSRF be funded in cash or permitted investments at closing.
C&H Commentary: CSIA proposes to satisfy the DSRF requirement through a surety bond from a qualified financial guaranty insurer rather than through cash funding. This approach preserves bond proceeds for the Project Fund and avoids the need to increase the aggregate par amount of the Bonds to generate sufficient proceeds for both the Project Fund and a cash-funded DSRF.
DSRF Requirement Calculation: Based on the proposed terms of the Series 2023A Bonds, the DSRF requirement is calculated as follows:
(i) Maximum annual debt service on the Series 2023A Bonds: approximately $11,610,000 (based on level-debt-service amortization at 3.25% over 30 years);
(ii) 125% of average annual debt service: this calculation requires the final amortization schedule, but based on the estimated annual debt service of approximately $11,610,000 (which, on a level-debt-service structure, would produce average annual debt service approximately equal to maximum annual debt service), 125% of average annual debt service is estimated at approximately $14,512,500, which exceeds the maximum annual debt service amount;
(iii) 10% of original par amount: $220,000,000 × 10% = $22,000,000.
The least of the three amounts is $11,610,000 (maximum annual debt service). This is the DSRF requirement.
Surety Bond Proposal: CSIA has been in discussions with Olympia Guaranty Insurance Corp. (Rachel P. Dominguez, Senior Vice President, Public Finance) regarding the issuance of a surety bond to satisfy the DSRF requirement. Olympia Guaranty has indicated its willingness to issue Surety Policy No. OG-2023-MUN-4718 in the face amount of $11,610,000, with the following terms:
• Policy Amount: $11,610,000
• Annual Premium: $23,220 (0.20% of surety amount, or approximately 2.0 basis points of par)
• Premium Payment: Payable at closing from costs of issuance, with annual renewal premiums payable from the Surplus Fund
• Term: Coterminous with the Series 2023A Bonds (expiring October 1, 2053)
• Rating: Olympia Guaranty is rated AA+ by Lakeshore Ratings Group and AA by Pinnacle Credit Analytics
The use of a surety bond in lieu of cash funding would free up approximately $11,610,000 of bond proceeds that would otherwise be deposited to the DSRF, increasing the amount available for the Project Fund by a corresponding amount. Alternatively, if the par amount of the Bonds is not adjusted, the surety approach would reduce the required par amount of the Bonds by approximately $11,610,000 (subject to sizing adjustments for OID, underwriters' discount, and costs of issuance). Either outcome benefits CSIA by reducing borrowing costs and interest expense.
CSIA Counter-Position: The DSRF requirement for the Series 2023A Bonds should be permitted to be satisfied by a surety bond from a qualified financial guaranty insurer rated at least "AA" by at least one nationally recognized statistical rating organization ("NRSRO"). Cash funding should remain available as an alternative method of satisfying the DSRF requirement (to be used if a surety bond is unavailable or becomes cost-ineffective), but should not be required.
The Debt-Service Reserve Fund Surety Bond Agreement will be structured as a tri-party agreement among CSIA, PNTC (as Trustee), and Olympia Guaranty Insurance Corp. The agreement will specify the claims procedures, including the Trustee's obligation to draw on the surety bond upon a debt-service deficiency and the replenishment obligations of CSIA to reimburse Olympia Guaranty for any draws. C&H will prepare the initial draft of the Surety Bond Agreement for circulation to all parties.
C&H notes that the use of a surety bond has implications under Code Section 148 for the treatment of the DSRF as a "reasonably required reserve or replacement fund." Leonard Cross will address these implications in the Tax Memorandum.
Status: Open — CSIA insists on surety bond satisfaction; Meridian to confirm investor acceptability.
III.P. Revenue Pledge Structure
Meridian Proposal: The Series 2023A Bonds are to be secured by a pledge of net water-treatment revenues on a parity basis with all of CSIA's existing outstanding revenue bonds.
C&H Commentary: The proposed parity revenue pledge is acceptable in principle and is consistent with the structure of CSIA's existing outstanding revenue bond program. The revenues constituting the pledged revenues include:
(i) Wholesale Water Treatment Service Charges received from the 14 participating municipal water and sewer districts under the Wholesale Water Treatment Services Agreements;
(ii) Connection fees charged to new users connecting to the regional water treatment system;
(iii) System development charges assessed on new development within the service area; and
(iv) Investment earnings on pledged funds held by the Trustee under the Bond Indenture (excluding investment earnings on the Project Fund during the construction period, which are addressed separately).
The pledge of net water-treatment revenues is statutory in nature, created by operation of Chapter 43.160A RCW. Under Section 43.160A.060 of the RCW, the pledge of revenues by CSIA creates a lien on the pledged revenues that is valid and binding from the time the bonds are issued, without the need for any physical delivery, filing, or further act. Accordingly, no UCC financing statement filing is required to perfect the lien on pledged revenues. C&H will include this analysis in the enforceability opinion and will prepare a separate memorandum on revenue pledge priority and perfection under Washington law (see Memorandum on Revenue Pledge — Priority and Perfection Under WA Law, to be circulated under separate cover).
CSIA's existing outstanding parity debt of $3,120,000,000 is secured by the same statutory pledge. The addition of the Series 2023A Bonds at $220,000,000 of par will result in total outstanding parity debt of $3,340,000,000. All parity bonds share the lien on pledged revenues equally and ratably, without priority or preference of any series over any other series.
C&H recommends that the Term Sheet and the Bond Indenture expressly confirm the following:
(a) No subordinate or superior lien on net pledged revenues will be created in connection with the issuance of the Series 2023A Bonds;
(b) All bonds issued under the Bond Indenture and all existing parity bonds share the parity lien equally and ratably; and
(c) CSIA retains the right to issue additional parity bonds (subject to the additional bonds test discussed in Section III.M) and subordinate obligations, provided that subordinate obligations do not impair the parity lien or the sufficiency of net pledged revenues to satisfy the rate covenant.
C&H will prepare the Revenue Pledge Agreement, which will serve as the instrument by which CSIA formally pledges net water-treatment revenues for the benefit of the holders of the Series 2023A Bonds and confirms the parity of the pledge with existing outstanding bonds.
Status: Agreed in principle; documentation details to be addressed in the Revenue Pledge Agreement and Bond Indenture.
III.Q. Flow of Funds
Meridian Proposal: Standard municipal revenue bond flow of funds in the following priority:
1. Revenue Fund — All gross pledged revenues deposited upon receipt
2. Operation and Maintenance Fund — Transfer of budgeted O&M expenses
3. Bond Fund (Debt Service) — Transfer of amounts required for principal and interest payments on all parity bonds