Chapter 7

Financing Capital Projects

by Connor H. Crews

Introduction

County and municipal officials are responsible for acquiring, constructing, and maintaining the facilities, equipment, and other capital assets necessary to perform public services.¹ Units of local government in North Carolina perform a wide variety of public services—and as a result, the cost and complexity of the capital assets that a local government might need to perform a given public service (e.g., water and sewer service or operation of a courthouse), can vary substantially according to the types of public services that a unit provides. Because the useful life of a capital asset can extend for multiple fiscal years, the tools that a local government uses to budget for and finance the acquisition or construction of capital projects differ from those used to budget and finance current assets or operating expenses.²

This chapter focuses on funding capital assets used solely or primarily for traditional governmental purposes and explores the five primary mechanisms available to North Carolina’s local governments to finance capital projects: (1) current revenues, (2) savings, (3) special levies, (4) debt, and (5) grants or partnerships.³ Table 7.1 lists the authorized financing mechanisms within each category, and the remainder of the chapter details the legal authority of local governments to use each financing mechanism.

Current Revenues

Current revenues are revenues that a unit of local government collects on a regular, recurring basis (e.g., each fiscal year).⁴ The largest source of current revenue in a unit’s general fund is typically the property (ad valorem) tax, followed by local sales and use taxes. Current revenues in a unit’s enterprise funds typically encompass user fees and charges.

Although units typically use current revenues to fund government programs and, in particular, to cover recurring operational expenses, including salaries and benefits, utilities, and supplies, many also use a portion of current revenues to fund capital projects. Local governments typically use current revenues to fund two categories of capital expenditures: (1) those falling below a certain dollar amount and (2) those recurring on a regular basis (e.g., maintenance and repair expenditures on capital assets). Some local governments establish in their annual budget ordinance the dollar amount below which they will fund any capital expenditures with current revenues. A particular recurring capital expenditure may exceed that amount, in which case a local government may still choose to finance it using current revenues.

Savings

A unit often must save current revenues over time to finance a capital expenditure. North Carolina’s local governments can do this in two ways: (1) by accumulating moneys in fund balance or (2) by allocating revenues to a capital reserve fund.

Fund Balance

Local governments use fund accounting to track their assets and liabilities.⁵ In a fund accounting system, each accounting fund contains its own subset of self-balancing accounts—and each fund has its own assets, liabilities, revenues, and expenses.

Several types of funds can exist in a fund accounting system, including a “general fund,” which is both the most common type of fund that local governments hold and which accounts for the majority of revenues and expenditures for general government purposes. Equity within an accounting fund—the difference between its financial assets (e.g., revenues) and liabilities (e.g., expenditures)—is known as “fund balance.”

Primary Purposes

Fund balance serves three primary purposes: (1) to provide sufficient cash flow to cover operating expenses, (2) to serve as an emergency or “rainy day” fund, and (3) to function as a saving mechanism for anticipated capital expenditures.

Covering Operating Expenses

Although the fiscal year for most units of local government and public authorities begins on July 1,⁶ many local governments do not receive the majority of their current revenues (in the form of property tax proceeds) until late December or early January.⁷ Therefore, a local government typically must rely upon cash reserves—accumulated in fund balance—from its prior fiscal year to cover expenditures in the first several months of its new fiscal year.

Maintaining an Emergency or “Rainy Day” Fund

Fund balance can also serve as an emergency or “rainy day” fund. In an economic downturn or in response to unexpected expenses (e.g., a natural disaster or pandemic), local governments may have difficulty generating additional revenues (through taxes, fees, or user charges) quickly. Fund balance can provide a local government with cash flow to cover unanticipated operating or capital expenditures.

Saving for Anticipated Capital Expenditures

Some local governments also use fund balance to save money over time for anticipated capital expenditures. For example, if a local government knows that it must finance a capital expenditure in the next several years, it might purposefully enlarge its fund balance in fiscal years preceding the expenditure. When the project begins, the local government can then appropriate moneys accumulated in fund balance to finance the project.

Proper Amounts of Fund Balance

North Carolina law limits the maximum amount of fund balance that a unit may appropriate in an annually budgeted fund, but it does not force units to maintain any minimum level of fund balance. The Local Government Commission (LGC), a division of the North Carolina Department of the State Treasurer responsible for overseeing local government financial-management practices, similarly does not require units to set any minimum amount of fund balance.⁸ Instead, the LGC has encouraged units of local government to “maintain a fund balance that is consistent with . . . peers that provide similar services”⁹ and use LGC-published memoranda that list fund balances available for all counties and municipalities¹⁰ to determine a unit-specific amount of fund balance to maintain on an annual basis. What may be an appropriate amount of fund balance for one unit (e.g., 8 percent of general expenditures or one month of operating expenditures) may be inappropriate for another.

The LGC recommends that each local government adopt a fund balance policy that can be used to develop operating budgets and provide for corrective action should fund balance drop below the intended level at the close of a fiscal year.¹¹ The LGC also has drafted a sample fund balance policy, which contemplates that certain portions of fund balance “should be contemplated as a funding source for capital needs.”¹²

Using Savings Held in Fund Balance for Capital Expenditures

Appropriating portions of fund balance for a capital expenditure is relatively simple. A governing board need only amend its budget ordinance or project ordinance to account for and authorize an expenditure for one or more capital projects.¹³ A governing board may need to take additional actions to authorize a unit to enter into a contract for the acquisition or construction of a capital project.¹⁴

Advantages and Disadvantages of Accumulating Savings for Capital Expenditures in Fund Balance

Using fund balance to save money for future capital projects affords flexibility to a local government’s governing board. Because state law does not dictate that a unit spend unrestricted fund balance on a particular project or asset, the board may use the moneys accumulated in fund balance to finance either operating or capital expenditures.¹⁵ This flexibility can be beneficial in the face of unexpected events. For example, assume that a county wishes to expand its solid waste disposal facility in approximately five years. The county’s board of commissioners begins to purposefully accumulate fund balance toward this goal, but in year three, the county suffers from an economic recession. In this case, the board may divert the accumulated fund balance—with the exception of any moneys restricted by statute, regulation, or grant condition—to meet unrelated operating expenses or more pressing capital expenditures.

Using fund balance as a mechanism to save for future capital expenditures also may create controversy. Citizens may question why a unit of local government continues to raise revenue (through taxes, fees, and other charges) when it has sufficient reserves to meet its annual cash flow needs. They also may not trust that the governing board ultimately will spend the accumulated fund balance on capital expenditures.

Capital Reserve Funds

Instead of accumulating savings for capital expenditures in fund balance, a unit of local government may establish a capital reserve fund and periodically appropriate money to it.¹⁶ North Carolina law enables a unit of local government to establish and maintain a capital reserve fund for any purpose for which it may issue bonds.¹⁷ Local government utilities must account for any proceeds of system development fees in a capital reserve fund, regardless of the type of capital projects that the moneys will be used to fund, unless the local government has pledged those revenues as security in a bond financing.¹⁸ In that case, the local government may deposit the proceeds of system development fees in the funds, accounts, or subaccounts in accordance with the relevant bond order, bond resolution, trust agreement, or similar instrument that secures the relevant bonds.¹⁹

Creating and Amending a Capital Reserve Fund

To create a capital reserve fund, the governing board of a unit of local government must adopt a resolution or ordinance stating:

1. the purposes for which the capital reserve fund is created,²⁰

2. the approximate periods of time during which the moneys shall be accumulated in the fund for each purpose,

3. the approximate amounts to be accumulated for each purpose, and

4. the sources from which moneys for each purpose will be derived.²¹

A local government’s governing board may appropriate funds from its annual budget ordinance to a capital reserve fund at any time.²² Whenever it makes an appropriation, the board must amend the capital reserve fund into which the money will be transferred to account for the additional revenue.

The board also can amend a capital reserve fund, at any time, to change the purposes for which the fund was originally created.²³ For example, assume that the governing board of a rapidly growing municipality anticipates a need to expand its water system within eight to ten years. The board establishes a capital reserve fund and allocates moneys to the fund on an annual basis for five years for the water-system expansion project. In year six, the municipality suffers from a major economic recession and its growth slows significantly, making a water-system expansion unnecessary. In that case, the governing board can amend the capital reserve fund to identify alternative capital expenditures for which it will expend funds previously accumulated for the water-system expansion (e.g., road improvements, vehicle acquisition, or construction of a new administrative building). The board could not, however, divert accumulated savings in the capital reserve fund to cover the municipality’s operating expenses (e.g., salaries and benefits).

Using Savings Held in a Capital Reserve Fund for Capital Expenditures

Expending moneys held in a capital reserve fund for a capital expenditure is a simple task. The governing board of a unit of local government must adopt an ordinance or resolution authorizing the withdrawal, the transfer of moneys to another fund (e.g., the general fund or an enterprise fund), and the expenditure of moneys for one or more of the capital projects or assets identified in the resolution or ordinance creating the capital reserve fund.²⁴

Advantages and Disadvantages of Accumulating Savings in a Capital Reserve Fund

A capital reserve fund provides a more formal mechanism to save for future capital expenditures than fund balance. A capital reserve fund might be viewed as providing more transparency than an accumulation of fund balance because the governing board of a local unit must specify in the resolution or ordinance creating the capital reserve fund the capital projects for which it will accumulate funds. However, appropriating money to a capital reserve fund also provides a governing board with less flexibility than accumulation of fund balance. Once a governing board appropriates funds to a capital reserve fund, those moneys cannot be used to finance operating expenses—they must be used to fund capital expenditures, even in an emergency or recession.

Special Levies

Units of local government derive most of their current revenues from revenue sources held in the general fund, including the largest revenue source held in the general fund for counties and municipalities: the property (ad valorem) tax.²⁵ Owners of real and personal property subject to ad valorem taxes pay those taxes to a taxing county or municipality without regard to whether they benefit from the services that either jurisdiction provides. Governing boards typically feel obligated to spend the proceeds of property taxes for services that provide general benefits to the community rather than services that offer benefits to a single geographic area or users of a particular public service.

Governing boards also often feel pressure to provide and fund increasing numbers of projects and services while maintaining or reducing the property tax levy. As a result, many counties and municipalities now rely upon mechanisms for targeted revenue generation like user charges or fees, which are paid only by the citizens or property owners that benefit most directly from a service that a county or municipality provides. For example, many municipalities at one time used property tax proceeds to fund solid waste services, including disposal facilities, convenience centers, and even curbside pickup. Now, however, many local governments across the country increasingly assess user fees or charges to cover some or all of the cost to provide these types of services.²⁶

Counties and municipalities commonly impose user fees or charges for wastewater utility services, recreational and cultural activities, health and mental services, ambulance services, parking, public transportation, stormwater, cemeteries, and airport usage. Many counties also rely on fee revenue to fund certain regulatory activities, including inspections and plan reviews.²⁷

User charges are typically an appropriate funding source for services that have specific, identifiable beneficiaries rather than the public at large.²⁸ And although financing capital projects with user charges is possible, it may present challenges. Some units attempt to apportion some of the capital costs associated with providing a particular service among users of that service. For example, a local government that operates a water or sewer system might assess a customer a monthly charge consisting of two components: (1) a variable usage charge that increases or decreases based upon a user’s actual use and (2) a fixed “overhead” charge.²⁹ The fixed “overhead” charge covers both operating overhead and at least some capital expenses.

In addition to user charges, North Carolina law also permits counties and municipalities to use targeted revenue generation to fund capital projects through four types of “special” levies: (1) “traditional” special assessments, (2) critical infrastructure assessments, (3) special taxing districts, and, to a limited extent, (4) development exactions.

Special Assessments

A special assessment is a charge levied against real property to pay for public improvements that benefit that property. It is neither a user charge nor a tax, but shares characteristics of each. Like a user fee, a special assessment is levied in some proportion to the benefit that the assessed property receives. Like a property tax, it is levied against property rather than individuals and creates a lien on each parcel of real property assessed.³⁰

The authority to levy special assessments provides units of local government with a potentially important tool to fund capital projects. Recouping some or all of the costs of a capital project that directly benefits a defined range of property owners can make financial and political sense. Using special assessments to finance public infrastructure projects that primarily benefit a particular set of property owners also can permit a governing board to expend property tax proceeds and other revenue sources in the general fund on projects that benefit a broader subset of a unit’s citizens.

Currently, North Carolina counties and municipalities have two statutory methods for imposing special assessments: (1) “traditional” special assessments and (2) “critical infrastructure” assessments. Using special assessments can permit a unit to recoup some or all of the costs of a particular project.

“Traditional” Special Assessments

North Carolina’s local governments have infrequently imposed “traditional” special assessments for a number of reasons.

First, state law limits the purposes for which counties and municipalities may levy such assessments. Counties may levy assessments to finance water systems, sewage collection and disposal systems, beach erosion control and hurricane protection works, watershed improvement projects, drainage projects, water resources development projects, local costs of N.C. Department of Transportation improvements to subdivision and residential streets located outside of municipalities, and streetlight maintenance.³¹ Municipalities may levy assessments to finance public improvements involving streets, sidewalks, water systems, sewage collection and disposal systems, storm sewer and drainage systems,³² and beach erosion control and flood and hurricane protection works.³³

Second, a county or municipality may pay all the costs of a project prior to levying special assessments. Only after a unit completes a capital project may it levy any special assessments, and assessments often are paid in installments over a number of years (up to ten). Some units have created special assessment revolving funds, using yearly special-assessment payments from former projects to fund the initial costs of new projects.³⁴ But establishing a sufficient revolving fund can take several years.

Third, the process used to levy the assessments—detailed below—is onerous.

Process of Imposing “Traditional” Special Assessments

To impose a “traditional” special assessment, the governing board of a county or municipality must follow the steps in Table 7.2.³⁵

Once a unit confirms the final assessment roll, the assessments become a lien on the real property assessed.³⁶ Although a unit may demand full payment of the assessments within thirty days of publishing the confirmation, it typically permits payment in up to ten yearly installments, with interest.³⁷

“Critical Infrastructure” Assessments

Beginning in its 2008 legislative session, the General Assembly authorized counties and municipalities to finance a wide range of capital projects through special assessments for “critical infrastructure needs.”³⁸

The authority to impose special assessments for critical infrastructure needs, modeled on similar legislation from other states, can assist counties and municipalities in financing public infrastructure projects that benefit new, private development. A unit may impose assessments, with payments spread out over a period of years, expecting that the ultimate owners of developed property (instead of a private developer or local government) will pay the majority of those costs. Like traditional special assessments, the unit can pay the costs of the project up front and recoup its investment over time through yearly assessment payments. But unlike traditional special assessments, state law permits a unit imposing a critical infrastructure assessment to borrow the initial costs of a project, pledge the assessment revenue as security for the debt that it issues, and use yearly assessment revenues to meet its debt-service obligations.³⁹ Alternatively, a unit may contract with a developer to construct the capital project and use the critical infrastructure assessment revenue to reimburse the developer, over time, for costs that it incurred.⁴⁰

A critical-infrastructure assessment is conceptually similar to an “impact fee.” An impact fee is a fee that a unit of local government levies on new development (typically as a condition of obtaining a building permit) to pay for public infrastructure costs that the new development imposes.⁴¹ Like it may with an impact fee, a municipality or county may use the proceeds of critical-infrastructure assessments to fund public infrastructure projects that new private development requires—but the critical-infrastructure assessment method typically imposes fewer costs on a developer than an impact fee does. Assuming the developer completes the project, many, if not most, of the payments will be collected after completion.

Counties and municipalities may finance a much broader array of public infrastructure projects through critical-infrastructure assessments than through traditional special assessments. Authorized projects include a variety of traditionally “public” projects, ranging from constructing and maintaining public roads to building public schools, and encompass most capital projects in which a county or municipality is authorized to engage.⁴² The sidebar above presents a list of authorized critical-infrastructure projects.

Advantages and Disadvantages of “Critical Infrastructure” Assessment Method

A unit may use critical-infrastructure assessment revenues to make its debt-service payments and pledge those assessment revenues to debt holders to secure the debt that it incurred. Therefore, unlike traditional special assessments, critical-infrastructure assessments allow counties and municipalities to borrow money to cover the cost of an authorized capital project without committing general fund revenues to the project.

Of course, a unit may not be able to collect all of the assessment revenues necessary to meet its debt-service obligations. However, a unit can use the remedies available for the collection of property taxes in collecting unpaid assessments. In fact, the trust agreement under which a county or municipality issues special assessment–backed debt likely will include a covenant requiring the unit to use similar policy and effort in collecting special assessments as it does for property taxes.⁴³

Even though counties and municipalities have robust authority to collect unpaid special assessments, debt backed by special assessments can pose more risk to investors than other types of local government debt (e.g., general obligation bonds). To compensate investors for this risk, special assessment–backed debt typically carries higher rates of interest than other types of borrowing.⁴⁴

Process of Imposing “Critical Infrastructure” Assessments

With some exceptions, the process of imposing “critical infrastructure” assessments is similar to the process of imposing “traditional” special assessments as detailed in Table 7.2.

Table 7.3 summarizes the major differences between the two methods of imposition. Of particular note, before a county or municipality may impose any critical infrastructure assessment, it must first receive a petition signed by a majority of the owners of real property to be assessed, whose real property also represents at least 66 percent of the assessed value of all real property to be assessed.⁴⁵ In setting this requirement, the General Assembly likely envisioned that a single or just a few individuals or entities (e.g., corporate developers) would own the subject properties at the time of assessment. The petition must include a description of the public infrastructure projects to be financed, their estimated costs, and an estimate of the percentage of estimated costs to be assessed.⁴⁶ A developer owning real property to be assessed would likely negotiate all of these points with a county or municipality prior to submitting a petition. Once a county or municipality receives a petition to impose a critical-infrastructure assessment, it generally must follow the same detailed statutory process to impose the assessments as is required for traditional special assessments.

Unlike traditional special assessments, for critical-infrastructure assessments a unit need not complete a project before confirming the final assessment roll. Instead, it may base its assessments upon an estimate of the total costs to perform the project.⁴⁷ A unit also is not limited to a ten-year repayment period as it is when imposing traditional special assessments. It can instead set a repayment period of up to twenty-five years.⁴⁸

Frequency of Use Since Initial Authorization

To date, only two units of local government—the Town of Hillsborough and the Town of Mooresville—have issued debt backed by critical-infrastructure assessments.⁴⁹ Similar mechanisms are used more frequently in other states, particularly in Florida, Georgia, and Texas.⁵⁰

Special Taxing Districts

A municipality or county might fund a capital project using targeted revenue generation by establishing a special taxing district. Although the North Carolina Constitution requires that a local government’s rates of property tax be uniform throughout the jurisdiction,⁵¹ it also authorizes the General Assembly to permit counties and municipalities to (1) delineate one or more geographic areas within the unit as special taxing districts and (2) levy taxes within those districts to finance or provide services or facilities to a greater extent than those financed or provided in other parts of the jurisdiction.⁵² The General Assembly has exercised that authority in several cases, most notably in authorizing counties and municipalities to create “service districts.”⁵³

Like special assessments, these special taxing districts are based upon the principle that those benefitting most directly from a government function should pay for it. But unlike special assessments, which must be assessed on a project-specific basis, a county or municipality can establish a special taxing district to fund a variety of projects or services benefitting properties in the district on an ongoing basis. Chapter 4, “Revenue Sources,” details what types of service districts counties and municipalities may establish, the process to establish a service district, municipal and county authority to levy taxes in service districts, and what types of projects a county or municipality may undertake in a service district.

A county or municipality may borrow money to fund capital projects located in a service district to the same extent, and in the same manner, as it funds similar capital projects located outside of a service district. In addition, a municipality may issue special obligation bonds to finance capital projects located in a municipal service district.⁵⁴

Counties and municipalities typically are subject to an additional procedural requirement when issuing general obligation (GO) bonds to fund capital projects in service districts. If the GO bonds are subject to voter referendum, a majority of the district’s voters must approve the issuance of bonds, in addition to a majority of the voters residing within the municipality or county.⁵⁵

Development Exactions

Local governments sometimes seek to impose development exactions to finance the cost of public infrastructure projects. Exactions typically take one of two forms: (1) a requirement that a developer compensate a unit of local government for the capital costs the unit incurred to acquire or construct public infrastructure that supports the development or (2) a requirement that a developer construct public infrastructure to support its development. Local governments in North Carolina have limited statutory authority to impose development exactions.⁵⁶

Borrowing Money

The most common method for financing costly capital projects is borrowing money. Neither current revenues nor savings or special levies are likely to generate sufficient revenues to finance the acquisition, construction, or equipping of a significant capital asset. Borrowing money allows a unit of local government to leverage future revenue streams—a unit obtains cash in the short term and uses future revenues to repay debt over time.

When a unit of local government borrows money, it agrees by contract—typically referred to as a “debt instrument”—to repay those that have loaned money to it. Should a local government breach its promise to repay its debt or any other promise it makes under the terms of the debt instrument, its lenders typically have legal rights to enforce repayment or force the unit to cure its default.

Debt instruments can take a variety of legal forms, but most commonly take the form of a bond. North Carolina’s local governments are authorized to issue general obligation bonds, revenue bonds, special obligation bonds, project-development-financing bonds, and limited obligation bonds. North Carolina local governments also may borrow money through installment financing contracts. This section addresses each of these mechanisms for issuing debt.

Security

When a local government borrows money, its most fundamental promise is to repay the debt it incurs. But in addition, a local government also may pledge to its lenders certain legal rights to force or “secure” the repayment of its debt. Those legal rights are known as “security.” Depending on the type of transaction, that security might take the form of, among other things, a right to force a defaulting local government to levy taxes to repay its debt, to require changes in the operation of a public enterprise that the local government operates, or to repossess certain property that the defaulting local government owns.

North Carolina law dictates what types of security a local government may pledge to its lenders in connection with each authorized method of borrowing. The type of security that a local government pledges can affect the form of debt instrument issued, whether a unit must obtain voter approval or approval from the Local Government Commission (LGC), and the cost of debt.

For each borrowing mechanism, Table 7.4 explains (1) the “primary” sources of security—those that a local government legally may and typically does pledge to its lenders and (2) the “secondary” sources of security—those that a local government sometimes, but less commonly, pledges in order to make a financing more attractive for lenders. The primary sources of security for each borrowing mechanism are discussed below.

Entities Involved

Borrowing money often requires a unit of local government to interact with a range of third parties. These outside entities might include bond counsel, financial advisors, underwriters, lenders, ratings agencies, trustees, and the LGC. Not all of these parties are involved in every borrowing, and local governments often complete simple, small borrowings without external guidance or oversight.

Bond Counsel

A private law firm acts as “bond counsel.” When a local government issues bonds, the primary duty of bond counsel is to render a legal opinion that addresses, among other things, (1) the validity of bonds that a local government issues and (2) the taxability of interest paid to holders of the bonds under federal and state income tax laws.⁵⁷ Local governments and the purchasers of their bonds typically require receipt of this legal opinion as a condition of closing a bond transaction. Prior to issuing its legal opinion, bond counsel guides a local government—in concert with a unit’s regular attorney—through the procedural steps required to issue debt under state law. Bond counsel also prepares the majority of the legal documents required to complete a bond issuance. Through its involvement throughout this process, bond counsel is able to provide its approving legal opinion when a transaction is completed.

After an issuance occurs, bond counsel also might advise a local government about how to comply with complex provisions in the federal tax code that regulate how a unit may spend or invest proceeds of “tax-exempt” bonds.⁵⁸ Bond counsel also might advise a local government about its obligations under federal securities laws to disclose certain facts affecting bonds issued or the local government’s financial condition.⁵⁹ The terms of an engagement letter between a unit of local government and a private law firm providing bond counsel services will dictate whether and at what expense these services will be provided.

If a unit of local government is contemplating a bond issuance, it should hire reputable bond counsel with prior experience advising a North Carolina local government in the issuance of debt.⁶⁰ In doing so, a unit should seek to understand the specific functions that bond counsel will perform during the initial issuance of the bonds and after the debt has been issued.

Financial Advisor

Although no law requires a local government to hire a private firm to advise it or advocate for its interests when issuing debt, many local governments hire private firms as financial advisors to assist with the structuring and sale of bonds. These financial advisors might analyze, among other things, a local government’s ability to add additional debt, its compliance with existing debt covenants, or the proper mechanism to finance a new capital project. A financial advisor that advises a local government in connection with the issuance of its debt—including advice with respect to the structure, timing, and similar matters of debt—must register as a “municipal advisor” with the federal Securities and Exchange Commission.⁶¹ “Municipal advisors” have fiduciary duties under federal law to act in the best interests of their clients.⁶²

A local government can engage a municipal advisor for a single debt issuance or for a range of services that extend beyond a particular transaction.⁶³ The staff of the Local Government Commission can and will assist a local government in considering the structure of its debt or the proper mechanism for financing a project, but unlike a private “municipal advisor,” these staff may assist in the Commission’s decisions to approve or deny a particular debt issuance.

Other Consultants

A local government may need to hire other consultants to complete certain types of bond issuances. In particular, a local government that issues revenue bonds—which are payable from the proceeds of certain revenue-generating assets (e.g., municipally owned water and sewer systems)—might hire a “financial feasibility consultant.” Such a consultant might produce a “financial feasibility report,” which projects the operating results of the revenue-generating assets securing the repayment of the bonds. The intent of this report is to demonstrate to potential investors that a local government will be able to service its debt and comply with certain financial covenants after issuing revenue-backed debt.⁶⁴

Underwriter or Lender

An underwriter is a financial institution that purchases an issue of local government debt for resale to institutional or individual investors. An underwriter may initially acquire bonds either by (1) competitive sale or (2) negotiation with a borrowing unit.

Most general obligation bond sales in North Carolina are conducted on a competitive basis; underwriters submit sealed bids to the Local Government Commission (LGC) to buy the bonds, and the LGC awards the sale to the firm providing the most favorable offer.⁶⁵ Other types of bond sales (revenue bonds, special obligation bonds, project-development-financing bonds, and limited obligation bonds) occur by negotiation.⁶⁶ In a negotiated sale, a local government selects one or more underwriters at the outset of a transaction and negotiates the financing structure and borrowing costs with the selected firm.⁶⁷

Underwriters that purchase and resell a local government’s bonds to investors must comply with certain federal securities regulations, including the SEC’s “Rule 15c2-12.”⁶⁸ With some exceptions, these underwriters must (1) obtain certain disclosure documents from the local government that describe the bonds to be sold and certain information about the issuer of the bonds, (2) distribute these disclosure documents to potential investors, and (3) reasonably determine that the issuer has agreed to provide continuing disclosure of certain information after the bonds are issued.⁶⁹ An underwriter typically hires legal counsel to advise it on the structure of the offering and its responsibilities, and a local government typically pays for the cost of such legal counsel at closing out of bond proceeds.

In some cases, a financial institution may not purchase a local government’s bond or debt in order to resell it to other investors. Instead, it may hold this debt on its own balance sheet. A financial institution participating in such a “private placement” may be referred to as a “lender” rather than an “underwriter.”

Rating Agencies

A “public offering” occurs when a unit of local government sells bonds to an underwriter that will be offered publicly (i.e., resold to individual and institutional investors). As a practical matter, bonds that are sold publicly must be rated.⁷⁰ At present, three nationally recognized credit rating agencies rate local government debt: Moody’s Investors Service, S&P Global Ratings, and Fitch Ratings. A bond’s rating can serve as an indication of its credit risk at a given point in time, and each credit agency has a slightly different methodology of determining a credit rating.⁷¹

A local government typically will submit a wide variety of information to a rating agency in order to receive a credit rating for a particular public offering of bonds. These disclosures can vary substantially but typically include information regarding the particular debt structure proposed; the unit’s financial condition, demographics, and management practices; and, if applicable, the revenue sources supporting the issuance of the bonds.

Trustee

A trustee is a corporate entity—typically an arm of a financial institution—that is involved in some, but not all, issuances of local government debt.⁷² Subject to the terms of the bond documents under which bonds are issued, a bond trustee usually takes several actions throughout the life of a bond. It might act on behalf of bondholders in the event a local government defaults under the terms of the bond documents, obtain certain disclosures from the local government over the life of the bonds, and, as a “paying agent,” collect a local government’s payments of principal and interest and ensure their proper application.⁷³

Local Government Commission

The Local Government Commission (LGC), a division of the North Carolina Department of State Treasurer, is a nine-member body responsible for fiscal oversight of local governments and public authorities in North Carolina.⁷⁴ The LGC must approve each new issue of general obligation bonds, revenue bonds, special obligation bonds, and project-development-financing bonds.⁷⁵ It also must approve some installment financings, certain leases, and other financial agreements.⁷⁶

In reviewing proposed issuances of debt, state law requires the LGC to consider certain criteria specified by statute that vary between different types of borrowing. Generally, the LGC must determine whether, considering its other debts, a unit can afford to borrow a proposed amount at a particular rate of interest.

The staff of the LGC will work with a unit throughout the borrowing process to help its officials determine the most advantageous borrowing method for a proposed project. The staff can also identify any deficiencies in the unit’s financial history or management practices that might prevent LGC approval. When contemplating an issuance of debt that will require LGC approval, local officials should contact LGC staff as early as possible for assistance (preferably after the initial scope of a capital project is determined).⁷⁷

Joint Legislative Committee on Local Government

In 2011, the General Assembly established the Joint Legislative Committee on Local Government as a legislative study committee.⁷⁸ The purpose of the committee is, among other things, to “review and monitor” local government capital projects (other than those relating to schools, jails, courthouses, or administrative buildings) that require both LGC approval and the issuance of local government debt exceeding $1 million.⁷⁹ The committee may only review and monitor capital projects—it has no authority to approve or reject a capital project or financing.

Any unit of local government embarking upon a capital project within the legislative committee’s purview (i.e., those that require both LGC approval and the issuance of debt exceeding $1 million) must submit a letter to the chairs of the committee, its assistant, and the Fiscal Research Division of the General Assembly at least forty-five days prior to the meeting at which the LGC will consider approval of the debt.⁸⁰ The letter must include (1) a description of the project, (2) the debt requirements of the project, (3) the means of financing the project, and (4) the source or sources of repayment for project costs.⁸¹ The LGC has encouraged units to consult their regular counsel or bond counsel when preparing this letter.⁸²

The committee may meet at the discretion of its co-chairs to review a proposed capital project⁸³ and may send a letter of objection or support to the LGC for a particular project. In addition, the committee may make periodic reports on local government capital projects that it reviews and also recommend that the General Assembly adopt legislation relating to local government borrowing authority.⁸⁴

Types of Authorized Borrowing

The General Assembly may only authorize units of local government to borrow money by general law—not by local act.⁸⁵ At present, North Carolina’s local governments may issue seven types of debt: (1) general obligation bonds, (2) revenue bonds, (3) special obligation bonds, (4) project-development-financing instruments, (5) bond anticipation notes, (6) installment financing contracts or limited obligation bonds, and (7) bonds or notes issued to the federal or state government to repay a loan from an agency of either entity.⁸⁶ The General Assembly also has bestowed borrowing authority upon certain types of public authorities.⁸⁷ Summaries of each debt mechanism follow.

General Obligation Bonds

Security and Authority

The strongest form of security that a county or municipality can pledge to secure the repayment of its debt is its “full faith and credit.” When a unit of local government makes such a pledge, it promises to take all actions within its power—including levying property taxes in any amount necessary—to repay the debt. Such a pledge creates a “general obligation” of the unit. For that reason, debt secured by a general obligation is called a “general obligation bond.”

The Local Government Bond Act is the primary source of authority for units of local government to issue general obligation (GO) bonds.⁸⁸ The Act specifies the types of capital projects that a county or municipality may fund with the proceeds of GO bonds.⁸⁹ Counties and municipalities can use the proceeds of GO bonds to finance most of the capital projects in which they are otherwise authorized to engage.

Requirements and Limitations

Although North Carolina law authorizes units of local government to issue GO debt for a wide variety of purposes, the process it imposes to issue such debt limits its practical importance. Prior to issuing a GO bond, a unit of local government typically must (1) hold a successful voter referendum before pledging its faith and credit, (2) ensure that a borrowing not exceed its “net debt” limit, and (3) obtain approval from the Local Government Commission.

Voter Approval Requirements

Except in limited circumstances, a unit of local government may not issue GO bonds unless a majority of its voters voting in a referendum approve such an issuance.⁹⁰ Voters participating in a referendum may be unlikely to support the issuance of GO bonds to finance controversial or less-popular projects (e.g., jails or landfills), and local governments often exercise caution when proposing the issuance of GO bonds to voters. Even referenda for popular projects, such as a park, can fail. For example, from November 2012 through November 2022, six of the eleven GO bond referenda that failed across the state were to finance parks and recreation projects.⁹¹

From November 2012 through November 2022, North Carolina voters approved 202 of 213, or 94.8 percent, of GO bond referenda.⁹² Although this high approval rate suggests that securing voter approval of a proposed GO bond issuance can generally be expected, it also suggests that local governments do not proceed with the lengthy process of issuing GO bonds and securing voter approval for projects expected to be controversial or unpopular in the community. Units of local government often use other borrowing mechanisms authorized under state law—for which no voter approval is required—to avoid the time and expense incurred in securing voter approval for a GO bond issuance.

Exceptions to the Voter Approval Requirement for General Obligation Bonds

A municipality or county need not obtain voter approval to issue certain types of GO bonds. In particular, as permitted by the North Carolina Constitution, the General Assembly has permitted the issuance of “refunding” bonds and “two-thirds” bonds without voter approval.⁹³

Refunding Bonds

A unit of local government issues refunding bonds to retire or “pay off” an existing debt. Most commonly, a unit will issue refunding bonds because interest rates have fallen and, as a result, the unit can issue debt at an interest rate lower than that of the debt to be paid off. If this is the case, a unit can lower its debt-service payments by issuing refunding bonds. Under North Carolina law, a unit need not obtain voter approval to issue GO refunding bonds.⁹⁴

Municipal bond investors often seek to prohibit bond issuers from paying off existing bonds prior to their maturity date (i.e., the date upon which an issuer must pay all remaining principal and interest on a bond).⁹⁵ Therefore, GO bonds often include provisions that prohibit the early retirement—known as the “call”—of a bond issue for a certain period of time (typically ten years).⁹⁶

In some cases, bond issuers can still take advantage of falling interest rates prior to the “call” date of a bond by using a mechanism known as “advance refunding.” In an advance refunding, a unit issues refunding bonds but, instead of using the proceeds of the refunding bonds to immediately retire the outstanding obligations, places proceeds in an escrow account controlled by an independent third-party (most commonly, a trustee). The trustee invests the proceeds of the refunding bonds, makes payments to the holders of the refunded bonds in accordance with the payment schedule for those refunded bonds, and retires (i.e., pays off) the remaining principal and interest on the refunded bonds on or after their call date.

Recent changes in federal income tax laws have decreased the usefulness of advance refunding. Prior to January 1, 2018, interest paid to holders of refunding bonds was exempt from federal income tax as long as the refunding bonds were issued at least ninety days prior to the call date of refunded bonds. In December 2017, Congress repealed that exemption for refunding bonds issued after January 1, 2018—making interest paid on refunding bonds federally taxable.⁹⁷ To compensate for the loss of the tax exemption, issuers must pay relatively higher rates of interest to holders of advance refunding bonds issued after January 1, 2018.⁹⁸

A local government interested in retiring debt prior to its maturity date should consult bond counsel to determine what options might exist for refinancing.

Two-Thirds Bonds

A unit of local government need not obtain voter approval to issue GO bonds in an amount equal to or less than two-thirds of the amount by which the unit reduced its outstanding indebtedness in the immediately preceding fiscal year.⁹⁹ A unit may only issue these types of GO bonds—known as “two-thirds bonds”—in the fiscal year immediately following the year in which it reduced its debt.

A unit’s reduction in outstanding indebtedness is determined only by reference to its net reduction in the amount of outstanding principal in a prior fiscal year—not by any interest that the unit pays. If a unit issues debt in a prior year, it may increase its overall outstanding indebtedness and therefore lack any ability to issue two-thirds bonds in a subsequent fiscal year.

With several exceptions, a unit may use non-voted two-thirds bonds for any purposes authorized by general law.¹⁰⁰ When the governing board of a county or municipality announces its intention to issue two-thirds bonds without securing voter approval, the unit’s citizens can force a referendum by submitting to the unit’s clerk a petition signed by at least 10 percent of the unit’s registered voters.¹⁰¹

Net-Debt Limitation

A unit may not issue general obligation (GO) bonds if the issuance would raise the “net debt” of a unit to 8 percent of the aggregate appraised value of property subject to taxation by the unit.¹⁰² The General Statutes prescribe a formula for calculating a unit’s “net debt,” which is reflected in Figure 7.1.¹⁰³ A county or municipality is likely to repay GO and installment financing debt with the proceeds of property taxes—and this limitation seeks to ensure that a unit has sufficient taxing capacity to support the debt incurred.

Figure 7.1 Net-Debt-Limit Formula

Click here to open Figure 7.1 in a new tab.

For many units, this “net debt” limitation is more theoretical in its limitation than practical.¹⁰⁴ However, some units set a target net-debt threshold in order to bolster their credit ratings.

Bond Issuance Process

The process to issue GO bonds that require voter approval is long and requires detailed planning and coordination among a unit’s staff, bond counsel, the Local Government Commission (LGC), and other third parties (e.g., financial advisors or ratings agencies).¹⁰⁵ Bond counsel typically assists a unit’s staff in the preparation of public notices, required statements that a finance officer must prepare or file, and documents to be approved by the governing board and the LGC. The LGC must approve all issuances of GO bonds—even those that do not require voter approval.¹⁰⁶

LGC Approval

State law prescribes an application process for units to follow when seeking the LGC’s approval of a GO bond issuance. But even prior to that formal process, the LGC’s staff—in particular, employees of the Local Debt Management Section of the North Carolina Department of State Treasurer’s State and Local Government Finance Division—can meet with a unit’s representatives to discuss plans for a bond issuance.¹⁰⁷

Application Process

To initiate the application process, a unit must file with the LGC an application for the approval of a GO bonds issuance.¹⁰⁸ The LGC may require the unit’s staff to meet with LGC staff prior to the acceptance of the application.¹⁰⁹

Adoption of Bond Order

After the LGC accepts the unit’s application, the governing board of the unit must adopt a “bond order,” which is the central document the governing board must approve prior to issuing a GO bond.¹¹⁰ Among other things, a bond order authorizes the issuance of the bond and states both the purpose for which the unit will spend the proceeds of the bond and the maximum amount of bonds that may be issued under the bond order.¹¹¹ If a unit proposes to issue GO bonds for unrelated purposes (e.g., schools and public parks), it must adopt a separate bond order for each purpose.¹¹² Bond orders authorizing the issuance of bonds for which voter approval is required do not take effect unless and until the voters approve them.¹¹³

Preparation of Sworn Statement of Debt and Statement of Disclosures Necessary for Bond Authorization

After a unit’s governing board has introduced a bond order authorizing the issuance of GO bonds, the unit’s finance officer must prepare and file with the clerk to the governing board a sworn statement of debt.¹¹⁴ This statement reflects the unit’s net debt, the assessed value of property subject to taxation by the unit, and the percentage of net debt compared to that assessed value.¹¹⁵ As discussed previously, that percentage may not exceed 8 percent.

As of October 1, 2022, the finance officer of a unit intending to issue GO bonds also must file a statement of disclosure with the LGC and the clerk to the governing board that contains (1) an estimate of the total amount of interest that will be paid on the bonds over their expected term, if issued, and a summary of the assumptions upon which that estimate is based; (2) an estimate of the increase in property tax rate, if any, necessary to service the proposed debt; and (3) the amount of two-thirds bonds capacity the unit has available for the current fiscal year.¹¹⁶

LGC Approval Criteria

North Carolina law requires the LGC to approve a debt issuance if it finds and determines all of the following:

1. The proposed bond issue is necessary or expedient.

2. The amount proposed is adequate and not excessive for the proposed purpose of the issue.

3. The unit’s debt-management procedures and policies are good or reasonable assurances have been given that its debt will henceforth be managed in strict compliance with law.

4. The increase in taxes, if any, necessary to service the proposed debt will not be excessive.

5. The proposed bonds can be marketed at reasonable rates of interest.

6. The assumptions used by the unit’s finance officer in preparing the “statement of estimated interest” are reasonable.¹¹⁷

In November 2022, the LGC adopted a “safe harbor policy” to govern its assessment that a unit’s finance officer used reasonable assumptions in the statement of disclosure when determining the total interest to be paid over the expected term of the bonds. Under that policy, the LGC will find such assumptions to be reasonable if they assume that (1) principal will be paid in twenty annual equal principal installments and (2) the interest rate on the bonds will be equal to a Bond Buyer 20 index (BB20) rate published within twenty-five days prior to the introduction of the bond order plus 200 basis points (2 percent) or higher.¹¹⁸

Voter Approval and Issuance of the Bonds

The governing board of a unit of local government must call for a referendum on the bonds to be held within one year after the bond order’s passage.¹¹⁹ After the bond order is approved by voters, the unit may issue bonds authorized under the bond order within seven years of the date upon which the bond order takes effect.¹²⁰ After the unit adopts a resolution fixing the details of bonds to be issued,¹²¹ the LGC sells GO bonds on behalf of the unit, typically on a competitive basis.¹²²

Revenue Bonds

Security and Authority

The State and Local Government Revenue Bond Act authorizes certain units of local government to issue “revenue bonds.”¹²³ Local governments issue revenue bonds to finance the acquisition, construction, or equipping of a single revenue-generating asset (e.g., a parking deck) or multiple assets contained within a revenue-generating system (e.g., water and sewer lines in a portion of a municipality’s water and sewer system). Although North Carolina’s local governments most commonly issue revenue bonds to finance water- and sewer-system projects, they also have legal authority to issue revenue bonds for gas or electric facilities, solid waste facilities, parking, marine facilities, auditoriums, convention centers, economic development, electric facilities, public transportation, airports, hospitals, stadiums, recreation facilities, and stormwater drainage.¹²⁴

When a local government issues revenue bonds, its obligation to repay the proceeds of those bonds is secured by a “pledge” of the revenue generated by the financed asset (e.g., a parking deck) or system of which the debt-financed asset becomes a part (e.g., a municipal water and sewer system). By law, holders of these revenue bonds have a lien on these pledged revenues,¹²⁵ and typically, if a local government fails to pay principal and interest upon the bonds as each becomes due, these bondholders can demand that a local government raise its rates or change the operations of its revenue-generating system in order to pay the debt service owed.

North Carolina law only allows units of local government to pay debt service on revenue bonds from revenues pledged as security for the bonds.¹²⁶ For example, a municipality that issues revenue bonds to finance the construction of a public parking deck may only use revenues generated by its operation of that parking deck (e.g., parking fees) to pay principal and interest to revenue bondholders. In most cases, holders of revenue bonds do not have a right to demand that a local government raise taxes or demand payment from any source other than the revenues of the financed asset or system.¹²⁷

Requirements and Limitations

Covenants

Because the revenues of an asset or system financed with revenue bonds both secure and serve as the source of repayment for revenue bonds, lenders and underwriters that resell bonds to investors typically require that revenue bond issuers agree to abide by certain restrictions when operating financed assets. These restrictions are known as “covenants.”¹²⁸

Although the exact form of covenants will vary by transaction, almost all issuers of revenue bonds can expect to make a “rate covenant.” Under a rate covenant, an issuer of revenue bonds typically agrees to set and collect the rates, fees, and charges of revenue-producing assets to ensure that the assets’ net revenues exceed annual debt-service requirements by a certain percentage.¹²⁹ For example, an issuer will commonly agree to ensure that its rates and charges will generate annual net revenues of between 120 and 150 percent of either the current year’s debt-service requirements or the maximum annual debt-service requirements during the life of the loan.¹³⁰ This margin of safety is referred to as “times-coverage” or a “debt service coverage ratio” and serves as a measure of the issuer to repay its debt without excess financial strain.¹³¹ If an issuer fails to meet its debt-service coverage ratio, bondholders may have certain rights to force the issuer to change the operations of the financed assets.

Issuers of revenue bonds also typically agree to certain restrictions on their ability to issue additional revenue bonds that are secured and payable from the same source of revenues as previously issued bonds.¹³² Known as an “additional bonds test,” this covenant generally permits an issuer of revenue bonds to issue additional bonds that are secured by and payable from the same source of revenues as outstanding revenue bonds only if the issuer can demonstrate that the net revenues have been and will continue to be sufficient to service the additional debt.

Lastly, revenue bond issuers also commonly agree to maintain various funds (e.g., a revenue fund, a debt-service fund, a construction fund, and a debt-service reserve fund).¹³³ Each of these funds is restricted by the terms of the bond documents under which the revenue bonds are issued. An issuer will commonly agree that a third-party trustee will maintain the proceeds of the revenue bonds and will disburse the proceeds of those bonds only upon the issuer’s submission of proper documentation (e.g., relevant evidence of construction pay applications).¹³⁴

Bond Issuance Process

The procedures required to issue revenue bonds under North Carolina law are much less extensive than those required to issue general obligation (GO) bonds. Other than securing Local Government Commission (LGC) approval and adopting a bond order at the proper time, state law imposes few procedural requirements upon a local government’s issuance of revenue bonds.

LGC Approval

Although a unit of local government need not obtain voter approval to issue revenue bonds,¹³⁵ it must obtain approval from the LGC to issue revenue bonds.

Application Process

A unit of local government seeking to issue revenue bonds must submit an application for approval to the LGC.¹³⁶ And, as with GO bonds, the LGC may require the unit’s staff to meet with LGC staff prior to the acceptance of the application.¹³⁷ Once the LGC accepts the unit’s application, it will consider whether to approve the proposed revenue bond issuance, and in doing so may consider, among other things, whether the probable net revenues of the financed assets will be sufficient to meet the debt service on the proposed revenue bonds.¹³⁸

The LGC must approve a revenue bond issuance if it finds and determines all of the following:

1. The proposed revenue bond issue is necessary or expedient.

2. The amount proposed is adequate and not excessive for the proposed purpose of the issue.

3. The proposed project is feasible.

4. The unit’s debt-management procedures and policies are good or reasonable assurances have been given that its debt will henceforth be managed in strict compliance with law.

5. The increase in taxes, if any, necessary to service the proposed debt will not be excessive.

6. The proposed bonds can be marketed at reasonable interest cost.¹³⁹

Ordinarily, the LGC will consider the approval of a unit’s application to issue revenue bonds at its regular monthly meeting.

Negotiating the Terms of a Revenue Bond Issuance

Revenue bonds are typically sold by negotiation rather than competitive bid, and a borrowing government typically selects an underwriter or placement agent at the outset of the negotiating process.¹⁴⁰ The terms of the bonds—in particular, the terms of an issuer’s covenants—are negotiated over a series of weeks or months by representatives of an issuing local government, its regular counsel, bond counsel, one or more underwriters or placement agents and their counsel, staff members of the LGC, and, in some cases, the financial advisor to the issuing local government.

Adoption of Bond Order

With input from all of these stakeholders, bond counsel typically reduces the relevant terms to a bond order. As is the case for GO bonds, the bond order is the central document that a governing board must approve prior to issuing revenue bonds. It will, in comprehensive detail, set out the amount and purpose of the borrowing, the security for the revenue bonds issued, and the covenants to which the local government has agreed.¹⁴¹

Unlike with GO bonds, a unit’s governing board may introduce a bond order for revenue bonds at any regular or special meeting and adopt it at the same meeting, as long as the unit has submitted its application for approval to the LGC.¹⁴² To approve a revenue bond issuance, state law does not require the unit to publish notice of a referendum or take any other procedural action other than approving the bond order.

Issuance of the Bonds

The LGC sells revenue bonds on behalf of a unit of local government, typically on a negotiated basis.¹⁴³ The date of sale is fixed by consultation with the LGC, the issuing unit of local government, its underwriter, and other parties involved in the transaction.¹⁴⁴

Special Obligation Bonds

Security and Authority

North Carolina law authorizes certain units of local government to issue “special obligation” bonds for a limited number of purposes.¹⁴⁵ In particular, counties, municipalities, and regional solid waste management authorities may issue special obligation bonds for solid waste management projects; certain water supply, conservation, and reuse projects; and wastewater collection and treatment projects.¹⁴⁶ Municipalities also may issue special obligation bonds to finance or refinance projects that they may otherwise undertake in a municipal service district.¹⁴⁷

Conceptually, a revenue bond is a type of special obligation bond because it is secured by and payable from a particular source of local government revenue. But the technical term “special obligation,” as used in North Carolina law, refers to debts secured by and payable from revenue sources other than (or in addition to) revenues from the financed asset or system of assets.

A special obligation bond may be secured by and payable from almost any revenue source available to the borrowing government. However, a unit may not issue special obligation bonds secured by the unit’s taxing power.¹⁴⁸ For example, a county could not issue a special obligation bond secured by the proceeds of local option sales and use taxes, animal taxes, or property taxes because it exercises its taxing power when it levies these taxes.¹⁴⁹ However, a municipality could pledge the proceeds of local option sales and use taxes that it receives from the Department of Revenue because only counties—not municipalities—have authority to levy those taxes.

Units of local government in North Carolina have issued special obligation bonds infrequently. As of July 1, 2022, only nine issues of special obligation bonds were outstanding across the state.¹⁵⁰

Requirements and Limitations

Because a special obligation bond is not secured by a unit’s taxing power, investors typically require an issuer of special obligation bonds to make covenants similar to those required for the issuance of revenue bonds. For example, a municipality might agree that if revenues pledged to pay and secure outstanding special obligation bonds are insufficient to meet a specific debt-service coverage ratio, it will add to the pledged funds a source of revenue other than a municipally levied tax in order to meet the coverage ratio.¹⁵¹

Bond Issuance Process

North Carolina law does not prescribe a strict statutory process that a unit of local government must follow to issue special obligation bonds. The LGC must approve all special obligation bond issuances, and a unit of local government must submit an application to the LGC to approve any such issuance.¹⁵² In considering whether to approve an application, the LGC may consider the same criteria as those applicable to a GO bond issuance, a revenue bond issuance, or both.¹⁵³ The LGC sells special obligation bonds on behalf of an issuing unit, typically in a privately negotiated sale.¹⁵⁴

Project-Development Financings

Security and Authority

Since 2003, North Carolina law has authorized local governments to engage in project­development financings.¹⁵⁵ Project-development financing is structurally equivalent to a type of borrowing in other states known as “tax increment financing” or “TIF.”¹⁵⁶ Public finance practitioners in North Carolina also often refer to project-development financing as “TIF.”

Project-development financing seeks to increase the aggregate property value in a currently blighted, depressed, or underdeveloped area within a county or municipality. A unit borrows money to fund public improvements within a designated area (known as a “development district”) with the goal of attracting private investment. The debt that a unit incurs to fund the improvements is secured and repaid by the incremental increase in property tax revenue resulting from the district’s new development.

The Project Development Financing Act permits counties and municipalities to issue project­development-financing bonds and use the proceeds for many, but not all, of the purposes for which either type of unit may issue GO bonds.¹⁵⁷ The act also allows local governments to use the proceeds for any service or facility authorized to be provided in a municipal service district, though no district actually need be created.¹⁵⁸ Table 7.5 sets forth all the purposes for which a unit may use the proceeds of project-development bonds.

Requirements and Limitations

The Project Development Financing Act sets out detailed procedural requirements for issuing project-development bonds. A unit must (1) define a financing district, (2) adopt a financing plan, and (3) secure various approvals from governmental entities.

Financing District

At the outset of a project-development-financing project, a county or municipality must establish a development-financing district that must consist of property that is

1. blighted, deteriorated, deteriorating, undeveloped, or inappropriately developed from the standpoint of sound community development and growth;

2. appropriate for rehabilitation or conservation activities; or

3. appropriate for economic development.¹⁵⁹

A municipal district must consist of property that meets at least one of the conditions set forth for a county district or that meets the criteria of an urban “redevelopment area” (as defined by G.S. 160A-503). A municipality’s planning commission may designate any of the following types of property as a redevelopment area:

1. property that is blighted because of dilapidated, deteriorated, aged, or obsolete buildings; inadequate ventilation, light, air, sanitation, or open spaces; high density of population or overcrowding; or unsanitary or unsafe conditions;

2. a nonresidential redevelopment area with dilapidated, deteriorated, aged, or obsolete buildings; inadequate ventilation, light, air, sanitation, or open spaces; defective or inadequate street layout or faulty lot layout; tax or special assessment delinquency exceeding the value of the property; or unsanitary or unsafe conditions;

3. a rehabilitation, conservation, and reconditioning area in present danger of becoming a blighted or nonresidential redevelopment area; or

4. any combination of the above types of areas.¹⁶⁰

The total land area within a financing district may not exceed 5 percent of the total land area of the taxing unit.¹⁶¹ A county may not include in a development-financing district any land located within a municipality at the time the district is created, but a county and municipality may jointly agree to create such a district.¹⁶² In the absence of such an agreement, any land in a municipally established development-financing district will not count against the 5 percent of unincorporated land in that county that may be included in a development-financing district.¹⁶³ If a county and municipality jointly create a development-financing district, and each unit pledges its incremental tax revenue in support thereof, the area included within the district likely counts against the 5 percent limit for both the county and the municipality.

Financing Plan and County Approval

Once a unit identifies a development-financing district, it must adopt a financing plan that includes the following:

• a description of the boundaries of the development-financing district;

• a description of the proposed development, both public and private;

• a listing of the costs of the proposed public activities;

• a listing of the sources and amount of funds that will be used to pay for the proposed public activities;

• a base valuation of the district;

• a projected increase in the assessed valuation of property in the district;

• an estimated duration of the development-financing district (the earlier of thirty years from the effective date of the district or when the bonds are repaid);

• a description of how the proposed public and private development of the district will benefit district residents and business owners in terms of jobs, affordable housing, or services;

• a description of appropriate ameliorative activities if the proposed projects negatively impact district residents or business owners in terms of jobs, affordable housing, services, or displacement;

• a statement that the initial users of any new manufacturing facilities included in the plan will be required to pay certain wages, unless exempted by the state Secretary of Commerce.¹⁶⁴

The unit must hold a public hearing on the proposed financing plan.¹⁶⁵ After the public hearing, a county governing board may approve the plan, with or without amendment, unless the plan has been disapproved by the secretary of the North Carolina Department of Environmental Quality (NCDEQ). A municipal board has an additional procedural requirement: it must provide notice to the governing board(s) of the county or counties in which the proposed district is located.¹⁶⁶ The county governing board(s) has twenty-eight days to disapprove the plan. If it is not disapproved by the county board(s), the municipal board may proceed to adopt the plan.

LGC and State Agency Approval

The plan and the district do not become effective until the Local Government Commission (LGC) approves the issuance of project-development-financing bonds for the district. The LGC may consider any matters it deems relevant to whether the bond issuance should be approved, including

1. whether the projects to be financed from the bonds are necessary to secure significant new project development for the district;

2. whether the proposed projects are feasible (taking into account additional security, such as credit enhancement, insurance, or guarantees, as discussed below);

3. the county’s or municipality’s debt-management procedures and policies;

4. whether the county or municipality is in default on any debt-service obligation;

5. whether the private development forecast in the development-financing plan is likely to occur without the public project or projects to be financed by the bonds;

6. whether taxes on the incremental valuation accruing to the development-financing district, together with any other revenues available under G.S. 159-110, will be sufficient to service the proposed project-development-financing debt instruments;

7. whether the LGC can market the proposed project-development-financing debt instruments at reasonable rates of interest.¹⁶⁷

Two other state agencies must approve certain types of project-development financings. If a development-financing plan involves the construction and operation of a new manufacturing facility, the plan must be submitted to the secretary of NCDEQ. The secretary’s review will determine whether the facility will have a materially adverse effect on the environment and whether the company that will operate the facility has previously complied with federal and state environmental laws and regulations.¹⁶⁸

The development-financing plan also must be submitted to the Secretary of the North Carolina Department of Commerce. The secretary must certify that the average weekly manufacturing wage required by the plan to be paid to the employees of the initial users of the proposed new manufacturing facility is either above the average weekly manufacturing wage in the county in which the district is located or not less than 10 percent above the average weekly manufacturing wage paid in the state.¹⁶⁹ The secretary may exempt a facility if certain criteria are met.

Bond Anticipation Notes

A unit of local government may, in certain cases, elect to issue “bond anticipation notes.” As the name suggests, bond anticipation notes are promissory notes that a unit issues in anticipation of a future bond issuance. ¹⁷⁰ They are secured primarily by the proceeds of future bonds issued¹⁷¹ and typically have a maturity of less than two years.

A unit might issue such notes if it has authorized a bond issue but does not wish to borrow the full sum at one time. It also might issue bond anticipation notes if it intends to use the proceeds of the notes for construction financing.¹⁷² A unit must obtain short-term construction financing when it intends to sell an issue of future bonds to the U.S. Department of Agriculture’s Rural Development unit (USDA-RD). USDA-RD offers long-term (up to forty-year) financing for the construction or repair of certain types of public infrastructure in rural jurisdictions. To be eligible for such long-term financing, a unit typically must (1) obtain short-term construction financing from a lender other than USDA-RD (e.g., a private financial institution) and (2) substantially complete the project to be financed. A unit issues a bond anticipation note in order to obtain short-term financing, and when the unit issues a long-term bond to USDA-RD, it uses the proceeds of that financing to pay off the initial short-term loan evidenced by the bond anticipation note.¹⁷³

A unit of local government must obtain approval from the LGC to issue bond anticipation notes,¹⁷⁴ and the LGC will sell any notes approved on behalf of the unit.¹⁷⁵

Installment Financings

The most common method of borrowing money for the majority of North Carolina’s local governments is “installment financing.”¹⁷⁶ North Carolina law permits counties, municipalities, and certain other units of local government to borrow money by entering into installment financing agreements.¹⁷⁷ Because a single statute—G.S. Chapter 160A-20—contains this authority, public finance practitioners in North Carolina often refer to this type of arrangement as a “160A-20” financing.

Security and Authority

Installment financing can, but frequently does not, involve the issuance of bonds. In its most basic form, an installment finance agreement evidences a loan transaction in which a local government borrows money to finance or refinance either (1) the purchase of real or personal property or (2) the construction or repair of fixtures or improvements on real property that the local government owns.¹⁷⁸

In an installment financing, a unit of local government must grant a security interest to its financier in the asset purchased or in the real property, fixtures, or improvements to that real property financed with borrowed funds—it may not grant a security interest in real or personal property that is not financed with the proceeds of an installment financing. For example, assume that a county uses an installment financing to finance the construction of a vehicle maintenance garage on county-owned land. The county may borrow money to finance the cost of constructing the garage and may pledge to the financing provider, as security, either the garage or the land upon which the garage is built (or both). However, the county may not pledge any other property it owns that is not acquired or improved with the financing’s proceeds (e.g., the county library).

A unit of local government can only grant a security interest in real or personal property which it owns. Therefore, an installment financing agreement is valid under North Carolina law only if a unit takes legal title to the financed property when the financing term begins. The vendor, bank, or other financier may not take title to the asset at the outset of a transaction and retain title until the loan securing the purchase price is repaid.¹⁷⁹ For example, if a municipality purchases a vehicle and obtains vendor financing with a five-year repayment term, the municipality must acquire a certificate of title to the vehicle when it takes possession of the vehicle—not at the conclusion of the financing term.

North Carolina law does not identify particular sources of revenue that a local government must use to repay debt incurred in an installment financing arrangement. A local government may use any unrestricted funds to repay the debt.

Forms of Installment Financing

Installment financings can take one of three general forms, each of which is described in more detail below.

Vendor Financing. A contract between a seller of real or personal property and a borrowing government, under which the seller loans money to a borrowing government to purchase the seller’s assets.

Lending Institution Contracts. A contract between a financial institution (i.e., a lender) and a borrowing local government, under which the financial institution loans money to a borrowing government to either (1) purchase real or personal property from a third-party seller or (2) contract to construct or repair fixtures or improvements to real property.

Bond Market Financing.

Limited Obligation Bonds. A financing in which a local government directly issues “limited obligation bonds,” either to an individual purchaser (e.g., a bank) or to one or more underwriters (which resell the limited obligation bonds to other investors), in order to (1) purchase real or personal property from a third-party seller or (2) contract to construct or repair fixtures or improvements to real property.

Certificates of Participation. A financing in which a nonprofit corporation makes a “loan” to a local government to finance the unit’s (1) purchase of real or personal property from a third-party seller or (2) contract to construct or repair fixtures or improvements to real property. In a contract between a unit of local government and a nonprofit corporation, the local government agrees to repay the loan to the corporation and grant to the corporation a mortgage on any real property improved, if any. In turn, the nonprofit corporation issues “certificates of participation” in the loan (i.e., rights to receive the revenues from the unit of local government) on the public market and assigns its granted rights to a trustee for the benefit of the purchasers of the certificates.

Vendor Financing

Vendor financing is the simplest form of installment financing. In a vendor financing, a seller of real or personal property enters into a contract with a borrowing local government.¹⁸⁰ Under the contract, the vendor conveys real or personal property to a local government and the local government agrees to pay the purchase price of the property to the vendor through a series of installment financing payments. These payments incorporate a principal component and an interest component.

In a vendor financing, a borrowing local government also grants a security interest to the vendor in the real or personal property purchased to secure its obligations to pay the vendor for the purchase price of the property.¹⁸¹ If the unit of local government fails to uphold its obligations under the contract, the vendor may repossess the personal property or foreclose upon the real property.

Lending Institution Contracts

More commonly, a local government entering into an installment financing will enter into two contracts: (1) a contract with a vendor to purchase property or improvements to real property and (2) a contract with a lending institution (commonly, a bank) under which the lender agrees to provide the borrowing government money to pay the vendor and the borrowing government agrees to repay the lender, with interest, in a series of installment financing payments. Under the first contract, a vendor conveys legal title in the real or personal property to the borrowing government. Under the second contract, the borrowing government grants a security interest in the assets purchased, improvements constructed, or land upon which improvements are constructed.

Bond Market Financings: Limited Obligation Bonds and Certificates of Participation

Installment financings frequently involve a single financing provider. But for large financings—particularly those that require a local government to issue more than $10 million in tax-exempt debt in a calendar year—local governments often turn to the bond market.¹⁸² In an installment financing conducted through the bond markets, a local government typically sells limited obligation bonds (LOBs) or a nonprofit corporation sells certificates of participation (COPs) to an underwriter or a syndicate of underwriters. An underwriter that participates in such a financing resells such LOBs or COPs to other institutional or individual investors.

In a limited obligation bond financing, a borrowing government directly enters into a “trust agreement” or “indenture” with a third-party trustee, under which the local government grants a security interest in the financed asset (typically land and any improvements constructed thereon) to the trustee for the benefit of the bondholders. If the borrowing government fails to make scheduled installment financing payments to the trustee, the trustee may foreclose upon the property and use the proceeds of any foreclosure to pay bondholders.¹⁸³ In this structure, each bond is considered a separate “installment purchase contract.”

As noted previously, the legal structure of a certificate of participation financing is slightly more complex than other financing methods but achieves the same economic result.¹⁸⁴ When a unit of local government is engaged in a LOBs or COPs financing, bond counsel and a variety of other third parties will be involved.

Requirements and Limitations

Non-Appropriation Clause

An installment financing contract must include a “non-appropriation” clause. Such a clause makes clear that (1) all of a local government’s obligations to repay debt incurred under the contract are subject to the decision of the unit’s governing board to appropriate funds for that purpose and (2) the unit does not pledge its taxing power to secure its obligations to repay installment financing debt.¹⁸⁵

In the event that a local government defaults under an installment financing contract, an installment financing provider’s sole remedy is to repossess or foreclose upon the personal or real property in which the local government has granted a security interest—and a non-­appropriation clause makes this explicit. An installment financing provider may not obtain a deficiency judgment against a defaulting local government in the event that the proceeds from a sale of foreclosed property are insufficient to repay the debt that the local government owes.¹⁸⁶

Non-Substitution Clause

An installment financing contract may not include a “non-substitution” clause.¹⁸⁷ Such a clause restricts the right of a borrowing local government to (1) “continue to provide a service or activity” or (2) replace or provide a substitute for any fixture, improvement, project, or property financed, refinanced, or purchased pursuant to the contract. ¹⁸⁸

Process for Entering into an Installment Financing Contract

North Carolina law does not prescribe a strict statutory process that a unit of local government must follow to enter into an installment financing contract. At a minimum, a local government must ensure that, where required, it (1) holds a public hearing and (2) obtains Local Government Commission (LGC) approval.

Public Hearing

A unit of local government that enters into an installment financing contract that “involves real property” must hold a public hearing on the contract.¹⁸⁹ At a minimum, contracts to finance the acquisition of land or construction of improvements on land would “involve real property.” A unit must publish notice of any required public hearing in a newspaper of general circulation in the jurisdiction at least ten days prior to the date upon which the hearing will be held.¹⁹⁰

A unit of local government may, but is not required to, hold a public hearing on an installment financing contract that only concerns the acquisition of personal property.

LGC Approval

The LGC must approve some, but not all, installment financings. To determine whether the LGC must approve a particular installment financing, a unit should answer the questions posed in the flowchart contained in Figure 7.2.

Figure 7.2 Installment Financings Subject to LGC Approval

* Note that multiple contracts involving the same undertaking should be deemed a single contract. The amount of a contract can be determined by adding the total of all sums due under each contract entered into for a single undertaking.

If a local government’s installment financing contract is subject to LGC approval, the unit’s staff should contact LGC staff as soon as possible to discuss the proposed financing. The LGC may require that the unit’s staff attend a preliminary conference with LGC staff to discuss the unit’s need for the financing, alternative financing structures, debt-management procedures and policies, and the financing process. After initial discussions with LGC staff, a local government’s governing board typically adopts a resolution authorizing its staff to file a formal application for approval to the LGC and directing its staff to request proposals for financing.

The LGC must approve the proposed financing if it finds and determines all of the following:

1. The proposed contract is necessary or expedient.

2. The contract, under the circumstances, is preferable to a bond issue for the same purpose.

3. The sums to fall due under the contract are adequate and not excessive for its proposed purpose.

4. The unit’s debt-management procedures and policies are good or reasonable assurances have been given that its debt will henceforth be managed in strict compliance with the law.

5. The increase in taxes, if any, necessary to meet the sums to fall due under the contract will not be excessive.

6. The unit is not in default in any of its debt-service obligations.¹⁹¹

The LGC need not make all of these findings if it concludes that (1) the proposed project is necessary and expedient, (2) the proposed undertaking cannot be economically financed by a bond issue, and (3) the contract will not require an excessive increase in taxes.

If the LGC tentatively denies an application based upon the information that a unit provides, the LGC must notify the unit.¹⁹² The unit may request a public hearing on its application, and the LGC may revisit its decision based upon testimony or other evidence presented at the hearing.¹⁹³ After a unit obtains LGC approval, it may proceed to close the installment financing.

“Synthetic” Project-Development Financings

Although project-development financing often is the most expensive way for units of local government to borrow money to fund public infrastructure projects, the structure is attractive to units because a unit does not pledge or obligate any of its current revenues. Instead, it pledges future revenue streams that new development will generate.

A “synthetic” project-development financing—or “synthetic TIF”—occurs when a local government determines that projected incremental revenues from new private development can justify a debt issuance to fund public infrastructure benefitting or encouraging that development. But rather than issue project-development bonds, the unit uses another form of authorized borrowing—typically, an installment financing under which the unit pledges a public asset itself as security for the loan—to fund the public improvement.

If private development occurs according to the unit’s projections, the unit can use new revenue generated by the private development to repay the debt. Because local governments in North Carolina can obtain good ratings on installment financing debt sold in the public markets, synthetic project-development financing is often a cheaper and less complex alternative to formal project-development financing.

Federal and State Loans

Counties and municipalities may borrow money from an agency of the federal government or from the State of North Carolina “for constructing, expanding, maintaining, and operating any project or facility, or performing any function, which such city or county may be authorized by general law or local act to provide or perform.”¹⁹⁴ On the state level, counties and municipalities most commonly obtain loans from the North Carolina Department of Environmental Quality (NCDEQ) to finance the construction or repair of water or sewer infrastructure. On the federal level, counties and municipalities most commonly obtain loans from the U.S. Department of Agriculture to finance the construction or repair of a variety of public infrastructure in rural areas.¹⁹⁵ This section briefly describes the type of loans available from NCDEQ.¹⁹⁶

State Loans: Clean Water State Revolving Fund, Drinking Water State Revolving Fund, Wastewater Reserve, and Drinking Water Reserve

NCDEQ, through its Division of Water Infrastructure, may make loans to eligible units of local government from the state-held Clean Water State Revolving Fund (CWSRF), Drinking Water State Revolving Fund (DWSRF), Wastewater Reserve, or Drinking Water Reserve.¹⁹⁷ Eligibility for a loan from the CWSRF or the DWSRF, each of which is funded in part by federal appropriations, is determined by reference to federal law.¹⁹⁸ Among other things, CWSRF loans can finance certain wastewater treatment and collection projects, stream restoration, and stormwater improvements, while DWSRF loans can finance water storage, treatment, or transmission and distribution systems.¹⁹⁹

NCDEQ may make loans from the Wastewater Reserve for wastewater collection and treatment projects, stormwater quality projects, and nonpoint source pollution projects;²⁰⁰ it may make loans from the Drinking Water Reserve for public water-system projects.²⁰¹

A unit of local government that receives any type of loan from NCDEQ may execute a debt instrument payable to the State to evidence its obligation to repay principal and interest to the State.²⁰² It also may pledge as security for the loan, among other things, the revenues of any financed water or wastewater system.²⁰³ The LGC must approve any loan into which NCDEQ and a unit of local government enter.²⁰⁴

The Taxability of Interest Paid to Holders of Local Government Debt

Units of local government in North Carolina can enjoy a substantial advantage in the capital markets when they borrow money. They may, with proper structuring, issue debt on a “tax-­exempt” basis, meaning that any interest paid upon such debt is not subject to federal income tax.²⁰⁵ Because such interest is exempt from federal income tax, holders of “tax-exempt” debt will accept a lower rate of interest than comparable “taxable” debt. A local government that issues “tax-exempt” debt can lower its borrowing costs.

Issuing “tax-exempt” debt comes with administrative costs. To preserve the tax exemption, local governments must comply with complex provisions in the Internal Revenue Code (the “Code”) and regulations promulgated by the Internal Revenue Service.²⁰⁶ Among other things, these provisions regulate (1) the allocation and expenditure of the proceeds of tax-exempt debt, (2) the sources of and security for repayment of tax-exempt debt, (3) the investment of the proceeds of tax-exempt debt, and (4) the use and disposition of property financed by the proceeds of tax-exempt debt.²⁰⁷ Bond counsel can assist a local government in understanding these provisions, but ultimately, the responsibility for compliance falls upon local government staff.

Tax Certificates

When a local government issues tax-exempt debt, bond counsel typically prepares a “tax certificate” that the unit’s ranking officials execute on the unit’s behalf. This document, which can be substantial in length, usually sets forth, among other things, (1) how the unit intends to expend tax-exempt bond proceeds, (2) from what sources and with what security it intends to repay and secure the tax-exempt debt, (3) how it intends to invest any proceeds of tax-exempt bonds, and (4) how it intends to operate the financed facility. In each case, bond counsel drafts such a certificate to ensure that, by strictly following its requirements, a local government can preserve the tax-exempt status of interest upon its debt.

“Taxable” Debt

A unit of local government that otherwise has authority to issue debt under North Carolina law is not necessarily required to issue “tax-exempt” debt. In some cases—and particularly when interest rates have fallen substantially—a local government may decide that an issuance of “taxable” debt in lieu of “tax-exempt” debt is worthwhile.²⁰⁸ Local governments should consult with their financial advisors, the LGC, and bond counsel when seeking to issue taxable debt.

Disclosure Obligations for Publicly Offered Debt

As discussed above (see “Underwriter or Lender”), an underwriter that purchases and resells a local government’s bonds to investors typically must comply with, among other regulations, U.S. Securities and Exchange Commission (SEC) Rule 15c2-12.²⁰⁹ Where it applies, Rule 15c2-12 prohibits an underwriter from purchasing or selling municipal securities unless it has “reasonably determined that an issuer of municipal securities . . . has undertaken [to provide certain information in Rule 15c2-12 to the Municipal Securities Rulemaking Board (an entity overseen by the SEC)] . . . in a written agreement or contract for the benefit of [the] holders of such securities.”²¹⁰ In practice, public finance practitioners typically refer to this requirement as a “continuing disclosure undertaking.”

The purpose of this SEC rule, on a very basic level, is to ensure that purchasers of municipal bonds can understand current risks associated with holding the bonds. Local governments that have agreed to provide such a continuing disclosure undertaking must provide certain information to the Municipal Securities Rulemaking Board through its Electronic Municipal Market Access (EMMA) system.²¹¹ Among other things, an obligated local government must provide to EMMA (1) “annual financial information”²¹² and (2) notices of sixteen specified events within ten business days after the occurrence thereof.²¹³ The LGC has released a variety of resources to assist local governments in complying with their disclosure obligations, and local governments may wish to consult bond counsel for advice in complying with an existing continuing disclosure undertaking.²¹⁴

Grant Funding for Capital Projects

North Carolina law authorizes counties and municipalities to accept grants from the federal or state government to construct, expand, maintain, and operate any project or program which state law permits the unit to provide or perform.²¹⁵ Local governments commonly use these grants to finance—in whole or in part—many types of capital projects, including the acquisition, construction, and equipping of affordable housing, water and sewer facilities, parks or recreation facilities, and other types of public infrastructure. The availability of federal and state grant funding can fluctuate according to the respective willingness of Congress or the General Assembly to appropriate grant funds.

Federal Grantmaking

Federal agencies may award a federal grant to a non-federal entity²¹⁶ only when Congress has (1) enacted legislation authorizing an agency to make a grant for a specific purpose and (2) appropriated money to the agency to provide the grant.²¹⁷ Once an agency has authority to fund a federal grant, it will announce the availability of the funding opportunity.

In most cases, an agency that awards a federal grant must release a public notice—termed a “notice of funding opportunity” or “NOFO”—that includes detailed information about the award, the types of entities eligible to apply, the evaluation criteria for selection, required components of an application, and how to apply.²¹⁸ NOFOs are accessible at grants.gov, a website maintained by the federal Office of Management and Budget. Local governments can use this website to identify and apply for federal funding opportunities.

Local Government as “Recipient”

A local government can receive grant funding directly from a federal awarding agency as a “recipient” of a federal grant.²¹⁹ If a federal agency selects a local government to receive a federal grant as a recipient, the agency typically will issue a notice of award, termed an “NOA,” and will require the local government to execute a grant agreement. A grant agreement is a legal instrument that reflects the terms and conditions upon which a non-federal entity may use awarded funds.²²⁰ Once a local government executes a grant agreement or accepts federal grant funds, it is contractually bound to the awarding agency to abide by the terms and conditions of the federal award.²²¹

Local Government as “Subrecipient”

A local government also might receive federal grant funding in an indirect fashion: by obtaining a “subaward” of federal funding from another non-federal entity—a “pass-through entity”—that is a recipient of federal grant funds.²²² For example, federal agencies commonly make a variety of grants to state government agencies. In turn, these state agencies commonly act as pass-through entities and subaward federal funds to local governments.²²³ A local government acting as a subrecipient will use awarded funds to carry out the objectives of the federal grant program and is obligated to use the funds in accordance with the terms and conditions of a subaward agreement and any other applicable laws and regulations that apply to the awarded funds.²²⁴

Complying with the Terms and Conditions of Federal Grants

As a recipient or subrecipient of a federal grant, a local government must act as a steward of federal funds. In particular, it must administer those funds in accordance with the federal statutes that authorized the grant and other governing laws, regulations, and terms and conditions specified in the grant agreement.

Although the laws and regulations that apply to each federal grant are unique, the federal Office of Management and Budget has made recent attempts to consolidate and streamline many of the regulations that govern the expenditure of federal grants into a single title of the Code of Federal Regulations: 2 C.F.R. Part 200.²²⁵ Entitled the “Uniform Administrative Requirements, Cost Principles, and Audit Requirements” and known popularly as the “Uniform Guidance” or “UG,” 2 C.F.R. Part 200 attempts to establish a uniform framework for the administration of federal financial assistance that federal agencies and non-federal entities must follow.

The Uniform Guidance (2 C.F.R. Part 200)

Comprised of six subparts and twelve appendixes, the Uniform Guidance addresses, in significant detail, (1) the obligations of federal agencies prior to awarding federal financial assistance to non-federal entities and (2) how non-federal entities must manage the expenditure of federal financial assistance. In general, recipients and subrecipients of federal grants must adhere to applicable provisions of the Uniform Guidance unless a granting agency has established an exception to those provisions in separate regulations or in a particular grant agreement.

Basic Compliance Requirements

Local governments that receive federal financial assistance, including federal grants, must be familiar with the compliance obligations that the Uniform Guidance imposes upon their expenditure of federal monies. Among other things, the Uniform Guidance

1. dictates and restricts which direct and indirect costs a non-federal entity may charge to a federal award;²²⁶

2. requires that a non-federal entity adopt and implement internal controls to ensure proper management of federal funds;²²⁷

3. requires that a non-federal entity, when acquiring property or services with the proceeds of federal financial assistance, adopt and follow documented procurement procedures and a conflict of interest policy that are consistent with state law and procurement standards set forth in the Uniform Guidance;²²⁸

4. mandates that a non-federal entity follow certain standards for the use, maintenance, and disposition of real property, equipment, or supplies acquired using federal financial assistance;²²⁹

5. requires that a non-federal entity retain records related to an award of federal financial assistance for a minimum period of three years;²³⁰ and

6. requires that a non-federal entity undergo a single audit or program-specific audit if it expends $750,000 or more in federal financial assistance during a single fiscal year.²³¹

Depending on the particular grant, other portions of the Uniform Guidance may apply, and prior to accepting a federal award, a local government should confirm all provisions applicable to its expenditure and management of federal funds.

Due to the complexity of complying with federal grant conditions in applicable federal laws and regulations, some units of local government that receive federal grants have started to develop and implement comprehensive grants-management compliance programs.

Remedies for Noncompliance

Failure to comply with the terms and conditions of a federal grant or with other federal laws or regulations applicable to the expenditure of federal financial assistance can have severe consequences for a local government. Among other things, a federal awarding agency may withhold cash payments from a noncompliant local government, disallow improper costs charged to a federal award, or even partially or completely terminate a federal award.²³² For more egregious acts of noncompliance, a federal awarding agency has authority to initiate suspension or debarment proceedings against a local government, which could prohibit a local government—either temporarily or permanently—from receiving federal grant funds.²³³

Opportunities to Secure State Grant Funding

In addition to passing through federal funds to units of local government across the state, the North Carolina General Assembly and various state agencies also regularly make state funds available to units of local government for a variety of purposes. The State of North Carolina regularly publishes a variety of grant opportunities and also has created a database where users can explore available grant programs.²³⁴ When expending state grant monies for capital projects, local governments may be required to execute a grant agreement with a state agency and follow principles and restrictions contained in the North Carolina Administrative Code that are similar to those in the Uniform Guidance.²³⁵

Conclusion

Units of local government face a variety of challenges when financing capital projects. They must understand their legal authority to finance the acquisition or construction of capital assets, decide which financing mechanisms may be appropriate for a given capital project, and balance the needs of current and future citizens in generating revenue to support each undertaking. North Carolina law provides a variety of tools to fund the initial costs of large and small capital projects, and governing boards and staff should think critically about these issues and the needs of their communities before embarking on a particular financing path.