Commentary

Scenarios

Works Consulted

Authors

Commentary

Introduction

Public libraries, like cities, counties, and other municipal corporations, may borrow money and issue bonds to reflect the borrowing. But each public library is limited in how it issues bonds and how much interest to pay by its state laws. For purposes of this chapter, we are using Michigan law as an example. Any public librarian must learn the rules applicable to the state and public library where they work or plan to work. For example, in Florida, municipal bonds require validation of their purpose by court order. Chapter 25, Florida Statutes (Bond Validation) 75.01 et seq. In Michigan, public purpose is solely determined by the local unit of government.

Most public libraries are funded from a variety of sources ranging from property taxes to grants and donations to state aid. For many libraries, property taxes make up the bulk of the revenues used to operate the library. Property taxes (also known as “ad valorem taxes”) are expressed as “millages” against the value of real and personal property. In addition, many libraries have the authority to issue debt to finance various capital improvements. That debt often comes in the form of issuing “bonds.” Bonds are simply a promise to pay the holder of the bond. They are similar to a loan in that principal and interest are repaid on the bonds over a period of time at a stated interest rate. But in many states, the form of the borrowing is important and one has to look to state law to determine which form is appropriate.

As bond counsel for over 20 years, learning as we worked with experienced partners and less experienced municipalities, we seldom thought about how many laws have an impact on the issuance of bonds – federal case law, state case law, state statutes, state regulations, federal tax law, federal securities law, federal regulations, and practices throughout the country. Bond counsel could joke among themselves, but never with other lawyers – not even bail bond lawyers (a totally different practice with criminals and bail promises).

Historical Treatment of Municipal Bonds

In the 1800s, in the absence of legal constraints, municipalities incurred substantial debts for the questionable public function of financing railroad companies that subsequently failed, leaving taxpayers in fiscal straits. For example, a community issued its bonds to assist a railroad in extending its line from a slightly bigger community to its neighbor, hoping that, if they built it, people would come and settle there. Unfortunately, the choice often failed – no one came. Or, in contrast, a railroad began laying tracks through an area just annexed by a city, only to be denied access by the city. But the city’s power to annex was not in existence, so the railroad won and the owners of houses built where the railroad was going lost their property, and the city lost their tax revenues.

The few taxable properties remaining in the city were required to pay taxes sufficient to pay the bonds. The taxpayers complained to the courts, saying the communities had no business issuing the debt in the first place and that taxation amounted to an illegal taking of their property.

Justice John F. Dillon of Iowa agreed, and declared two bond issues invalid in 1868, resulting in “Dillon’s Rule.” This “rule” affirmed a narrow interpretation of a local government’s authority, in which a substate government may engage in an activity only if it is specifically authorized by the state government.

Although there was a short time when a Michigan judge’s ruling allowed some “home rule” for some cities, his ruling was contradicted by the Supreme Court twice in later years. Since then, the following tenets of Dillon’s Rule have become a cornerstone of American municipal law and have been applied to municipal powers in most states:

• A municipal corporation can exercise only the powers explicitly granted to them
• Those necessarily or fairly implied in or incident to the powers expressly granted
• Those essential to the declared objects and purposes of the corporation, not simply convenient, but indispensable (Cities 101: Delegation of Power).

State Laws Governing Municipalities – Bonds and Millage

Dillon’s Rule led to state statutes authorizing versions of “home rule,” the power to levy property taxes, and the power to borrow money and issue bonds. For example, in Michigan there are statutes organizing counties MCL 46.1 et seq.; charter counties MCL 45.501 et seq.; cities MCL 117.1 et seq; townships MCL 41.1a et seq; charter townships MCL 42.1 et seq; public libraries (owned by cities, villages and townships) MCL 397.201 et seq; and district libraries MCL 397.171 et seq, among others. In all cases, the power to borrow money was added years after the organization was permitted to be created by law. See, for example, MCL 117.4a, amending the Home Rule Cities Act 20 years after the act was first enacted, for city issuance of bonds, and 397.182 amending the District Library Financing Act 13 years after it was first enacted, for the issuance of district library bonds.

No municipality in Michigan can levy whatever tax it wishes, however. Instead, property taxation is limited by the Michigan Constitution and by State law, as well as by what the voters of a municipality approve. In each case, the limitation includes restrictions on the amount of money a municipality can accumulate annually, and how the municipality may use that money.

First, how are taxes in Michigan calculated? In general, property tax is expressed as a millage against the value of land and, sometimes, personal property. “Millage” is the amount of tax per $1,000 of “taxable value.” “Taxable value” is one half (or less) of market value, as assessed by the assessor. For example, if a statute authorizes a municipality to levy 4 mills and the taxable value of property in the municipality is $100,000,000, the municipality is permitted to collect $400,000 that year. [Note: There are several ways in which “taxable value” is far less than the ignore them. See, e.g., Michigan Constitution Article IX, Section 3.]

Take the City of Escanaba, Michigan. The City has a city band, police and fire departments, a city electric utility, a public library, marinas, public parks, and water and sewer services. All of these, plus the City’s employees in the various departments, are supported by the income received by the City annually, from a variety of sources.   The City could levy separate millages for the library (MCL 397.210a) and the band (MCL123.862), but it levies a total of 17 charter authorized mills for all its general fund obligations, including the library and the band. City of Escanaba, 2019-20 budget. www.escanaba.org/sites/default/files/fileattachments/assessor/page/2131/2019_millages_pdf_2019_millage_rates.pdf Its annual millage of 17 mills in 2019-2020 was $5,225,000. Of that amount, the City transfered $400,000 to the public library for operations. www.escanaba.org/sites/default/files/fileattachments/controller/page/2371/lf_final.pdf

The City of Wayne, Michigan, held an election in 2018 and the voters approved 1 mill for 10 years to support the Wayne Public Library bringing the Library approximately $700,00 annually. wayne.lib.mi.us/WPL%20Annual%20Report%202018-19.pdf

Wayne’s neighbor, Saline, Michigan, has a district library comprised of the City of Saline and the School District of Saline that levies a district library millage bringing the Library approximately $1,500,000 in 2020. www.salinelibrary.org/wp-content/uploads/2019/12/SDL-FY2019-2020-Budget-Summary.pdf

In each of the above cases, the public library has additional funds that are not from property taxes. Each receives some State aid, as well as revenues from fees and fines related to borrowers from the library. Some receive funds from private donations and grants. See, for example, Saline District Library budget. Before they were authorized to levy any millage, these were the sole sources for operating and capital improvement costs.

Howell District Library was formed by agreement between the City of Howell and the Howell Public Schools before 1988. howelllibrary.org/library-history/ It was a Carnegie Library and proud of its history, but it needed improvements immediately and its annual income did not support the total amount necessary. The Library then planned to borrow money and issue bonds to finance its improvements and approached Miller, Canfield, Paddock and Stone, PLC, to serve as bond counsel to the Library in issuing the bonds. Miller Canfield looked for authorization for a district library to do so and found it was not in the laws of the State.

As a result, with the efforts of the Michigan Library Association and State representatives and the State senator from the area, the State Legislature adopted the District Library Financing Act, MCL 397.281, et seq. The District Library Financing Act authorizes district libraries to acquire, construct, or furnish real or personal property for use for library purposes; to borrow money and issue bonds and notes for those acquisitions; and to levy a tax for, and to pledge their full faith and credit to, the payment of contracts, bonds, and notes. The Act also sets forth the maximum amount of debt that a district library can incur for such purposes.

Most bonds issued by municipalities, including libraries, in Michigan are also subject to the Revised Municipal Finance Act, MCL 141.2101, et seq. The Revised Municipal Finance Act is a broad reaching statute that sets forth requirements for municipalities to borrow money and issue bonds and other securities for various purposes and includes, among other things, restrictions on the types of debt to be incurred, the specific terms of such debt relating to payment frequency, sources of repayment, redemption rights and maturity limitations.

State and Federal Securities Laws Governing What a Municipality Tells Bondholders

Bonds are typically sold one of two ways: (1) through a competitive bidding process where a notice of sale is published in a national bond publication (such as the Bond Buyer) and bids are taken from any interested purchaser on a particular date and time or (2) through a negotiated sale either directly to a bank or other financial institution or to an investment banking firm (often called an “underwriter”) who then sells the bonds to its clients.

Often in larger bonds issues (typically $1,000,000 or more), whether sold through a competitive or negotiated sale process, an “official statement” is prepared setting forth information relating to the bonds (payment structure, security, redemption provisions, tax status, etc.) and economic and financial information relating to the issuer of the bonds (i.e. the library).

As you can imagine, there are many rules regulating the securities markets in the United States. Some of them apply directly to municipalities (like the anti-fraud rules) and some apply indirectly through other market participants such as underwriters (like the continuing disclosure rules).

The “antifraud rules” apply to every participant in all of the securities markets in the United States. The legal standard for disclosure is set forth in Section 17a of the Securities Act of 1933 and Section 10 of the Securities Exchange Act of 1934. Market participants frequently use the phrase “10b-5” as shorthand when referring to the antifraud provisions generally. SEC Rule 10b-5 (17 C.F.R. 240.10b-5) prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. In practice that means that the official statement used to market and sell bonds has to include all information, and cannot exclude information, that an investor would need to make an informed investment decision.

In 1975, Congress enacted the Tower Amendment which prohibits the Securities Exchange Commission (SEC) or Municipal Securities Rulemaking Board (MSRB) from directly or indirectly requiring issuers to file municipal securities documents with them before securities are sold. However, the SEC regulates municipalities indirectly through dealers (i.e. underwriters), which are subject to direct regulation. For example, SEC Rule 15c2-12 imposes requirements on underwriters regarding issuer disclosure practice in the primary and secondary markets. Rule 15c2-12 is the rule that requires the underwriter to review an official statement that is deemed final by the issuer before purchasing or bidding on bonds. It also prohibits an underwriter from purchasing or selling municipal securities unless it has obtained a commitment from the issuer of the securities to provide certain annual financial information and event notice.

Over the years, the SEC has taken action directly against municipal issuers for securities fraud relating to material misstatements or omissions from official statements and in 2014 initiated the Municipalities Continuing Disclosure Cooperation Initiative (MCDC) to address potential widespread violations of the federal securities laws by municipal issuers and underwriters in connection with certain representations about continuing disclosures in bond offering documents. Pursuant to the MCDC, the SEC entered into settlements with 71 issuers covering 45 states and 72 underwriters with charges against the underwriting firms totaling over $18 million.

Federal Tax Laws Governing Municipal and State Bonds

In 1913, after the adoption of the Sixteenth Amendment to the United States Constitution, the federal government adopted a federal income tax. Exempt from that law was interest on State and municipal bonds. For a very brief explanation of this early law, see Municipal Bonds for America’s article at www.munibondsforamerica.org/cms/wp-content/uploads/2013/07/Federal-Tax-Code-Fun-Facts-and-Trivia1.pdf

As noted in that article, what was once a document of merely 27 pages has grown enormously.

Basically, if a bond is issued by a governmental unit (defined) for governmental purposes (defined), the interest on the bond is exempt from taxation by the federal government. The City of X (definitely a governmental unit) issues $500,000 bonds to pay for public roads in the City (definitely a public purpose). The purchaser of those bonds pays no income tax on the annual or semiannual interest payments.

But if that same City of X (still a governmental unit) issues $500,000 bonds to finance roads in a golf course owned by a private entity, the purchaser of those bonds pays income tax on the annual or semiannual interest payments because the bonds were not used for a governmental purpose because they specifically benefited a private entity as opposed to the public in general.

Simple – correct? And yet, the Internal Revenue Code now has Section 103, Sections 141 to 150, and Sections 1395, 1400 and 7871 to clarify and further limit this conclusion.

Of course, many bond issues are not as simple as the examples above and that is why the Internal Revenue Code has become much more complicated over the years. Take this scenario – a public library (a governmental unit) issues $1,500,000 to finance the construction and furnishing of a library (public purpose) but as part of that library it leases more than 5% of the space to a private entity to operate a coffee shop. You would think that the interest would be tax-exempt since it was issued by a government unit for a public purpose. However, because more than 5% of the space is leased to a private entity (not a governmental purpose), the interest on the bonds would be taxable to the holder.

The Role of Bond Counsel and Other Participants

Why did the Howell District Library go to bond counsel? Its director knew that the Library could not issue bonds without an opinion of bond counsel. But why?

At the beginning, bond counsel was called as independent counsel into every bond issue after Dillon’s Rule and other cases invalidated bonds. The reasons for invalidation were many, including the allegation that the person who signed the bond was not authorized. Coler v Cleburne, 131 US 162 (1889). In that case, the bonds were ante-dated and signed by the former mayor, when the law required the bonds be signed by the then elected mayor.

A municipality would proceed to issue bonds, and a bank or other purchaser would hire an independent counsel (paid for by the municipality) to check out all of the following:

• Are the bonds legal? i.e., were they approved according to the applicable state laws?
• Are the bonds valid? i.e., have they been signed by the appropriate, authorized parties?
• Are the bonds binding? i.e., is there no way the municipality may claim later in time that something was wrong with the issue and the municipality need not pay the bondholders?

Later, when the Internal Revenue Code authorized the principal and interest payments on the bonds to be exempt from federal income taxation, bond counsel developed additional expertise in applicable sections of the federal income tax laws, and gave the opinion that the bonds were exempt from federal income tax. And municipal issuers hired bond counsel as an independent, but involved, voice in their bond process. Bond counsel’s role is to make sure the municipality follows all the rules to assure bondholders that the bonds are legal, valid, and binding, and that interest on the bonds is exempt from federal taxation.

Other organizations also now play important roles in the issuance of bonds. These include financial advisory firms who assist with assuring there will be sufficient revenues to pay the bonds. The architect or engineer (or both) is also important to the issuance, because of their involvement in the validity of public purpose as well as design of what is being financed. And if the bonds are “privately placed” (that is, not offered by advertisement), the public library must select an underwriting firm that will purchase and further offer the bonds for sale to its select purchasers. Local bond counsel’s role usually involves explaining the purpose of each participant.

Scenarios

Scenario 1:

You are the director of a city public library currently located in rented space in an older, deteriorating building owned by the local school district. The school district has decided to tear down the building and pave over the lot for a new parking lot for the high school. A local philanthropist is willing to donate a parcel of land in a prime location to the public library if the library is able to raise funds to build a new building, furnishings, and an expanded library collection. What do you do?

Scenario 2:

Your taxpayers complain loudly that you will be paying more than you should for interest on the bonds you issue, plus the cost of all the participants. Which is better for your public library: saving money collected from taxes until you have enough to carry out your project, or borrowing money and paying interest on bonds for that purpose? How long will it take you to get the money necessary to carry out the project?

Works Consulted

“Cities 101: Delegation of Power.” National League of Cities, www.nlc.org/resource/cities-101-delegation-of-power.

City of Escanaba website, www.escanaba.org

Coler v. Cleburne, 131 U.S. 162 (1889).

Florida Bond Validation, Chapter 25, Florida Statutes (Bond Validation) 75.01 et seq.

Internal Revenue Code (IRC), 26 U.S.C. § 1 et seq.

“Library History.” Howell District LIbrary, howelllibrary.org/library-history/.

Michigan District Library Financing Act, M.C.L 397.281 et seq.

Michigan Revised Municipal Finance Act, M.C.L. 141.2101 et seq.

Municipal Bonds for America. The Municipal Bond Tax Exemption &the Original, 1913 Federal Tax Code, www.munibondsforamerica.org/cms/wp-content/uploads/2013/07/Federal-Tax-Code-Fun-Facts-and-Trivia1.pdf.

Municipalities Continuing Disclosure Cooperation Initiative (MCDC), www.sec.gov/divisions/enforce/municipalities-continuing-disclosure-cooperation-initiative.shtml

Saline District Library website, www.salinelibrary.org/wp-content/uploads/2019/12/SDL-FY2019-2020-Budget-Summary.pdf.

Securities and Exchange Commission (SEC) Rules, www.sec.gov/rules/final.shtml.

Wayne Public Library website, wayne.lib.mi.us/WPL%20Annual%20Report%202018-19.pdf.

Authors

Thomas D. Colis

Thomas D. Colis (he/him/his) is a principal and Deputy Practice Group Leader of the Public Law Group of Miller, Canfield, Paddock and Stone, P.L.C. He is also one of five Managing Directors of the Firm. He has practiced law since 1993. He specializes in municipal finance including all aspects of financings for cities, villages, townships, counties, school districts, libraries, colleges and universities. He also specializes in economic development finance, including financing for manufacturing companies and non-profit entities. He received his law degree from The University of Michigan Law School in 1993, and a B.A., magna cum laude, from The University of Rochester in 1990.

Cynthia B. Faulhaber