In cash-hungry Upland, city employees are increasingly conscious of a pending $83 million unfunded liability stemming from overly generous pensions promised to employees in the past coupled with inadequate provisions to pay for them. Late last month, they brought in a prospective city consultant to brief the city council and a collection of citizens with regard to using arbitrage to extract money from city residents in the form of greatly increased water rates.
Using terms that many in attendance could not fully understand, the consultant, in not so many words, essentially disclosed that the money obtained from those water rate increases would be split three ways. Some of it would go to a company that would lease the water and wastewater divisions or in some other fashion be brought in to “manage” the city’s water and sewer systems, he said. City Hall would be empowered to take a percentage of that money to make sure that the city’s obligation to the state retirement system is satisfied and ensure retired city staff members receive their pensions, he said. And, he added hopefully, a percentage of the money to be generated would go to the attorneys or law firm who will charge a fee for completing the documentation relating to disclosure, financial counsel and underwriting of the deal to complete the transaction.
Don Hunt, who is with the firm Norton Rose Fulbright, was the prospective city consultant who provided that briefing during a workshop held at City Hall on February 23. Hunt is looking to churn fees by involving his firm as a consultant in any transactions the city council consents to engaging in with regard to its water and sewer utilities. He sought to sell the council on how it could use a long-term lease of its water and sewer systems to generate cash through arbitrage, that is, profiteering by the introduction of a middleman who purchases something at one rate and then resells it at a substantially higher rate.
By engaging in an elaborate mechanism involving leasing those utilities to a corporation which would then be free to jack up water and sewer rates, doubling, tripling or quadrupling what Upland residents pay for their water and sewer service, Hunt intimated that the city could generate money to make sure that retired city workers receive their pensions and that the company that comes in to perform the managing function for Upland’s municipal utilities could make a tidy profit. Slyly, Hunt was hoping the city would buy into the idea and hire his firm to carry out the legal work related to it, so he could make some money, too.
How would this be accomplished? Through a process akin to arbitrage.
Merriam-Webster defines arbitrage as “the nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies” or “the purchase of the stock of a takeover target especially with a view to selling it profitably.”
In this case, the “stock” consists of the city’s water supply, its water reservoirs and delivery system and its sewer system. Technically, the city would not actually “sell” those assets but rather lease them to a company, which would then deliver the water to the city’s customers, i.e., its residents and businesses, and provide sewer services to the same. The company would be free to increase – and increase dramatically – what the City of Upland’s customer base pays for that commodity and service. The company would spring back to the city a substantial amount of money in the form of the lease payment it would pay to the city. The city would make further savings by no longer having to operate, maintain and manage the water and sewer systems. The city could redirect the money realized from these savings and the lease income toward staying abreast of its payments to the California Public Employees Retirement System, known by its acronym, CalPERS. At the same time, the company would be able to realize a substantial return on its investment by upping the bills it would provide to city residents for the water and sewer service.
Without directly saying so, Hunt suggested to the city council at the February 23 workshop he hosted at Upland City Hall with all five members of the city council present and a crowd of some thirty to forty residents and city staff members, that the city might sidestep the wrath of city residents over the rate increases since it would be the company that leased the municipal water and sewer divisions that would be doing the billing and not the city.
Hunt emphasized that a lease agreement would not technically fall into the category of outsourcing or privatization of the water system and sewer division assets, such that the city would still own them. Rather, he articulated a plan that would entail a 55-year lease of those assets and the creation of a joint powers authority involving the city and the company doing the leasing. The joint powers authority would issue bonds and the lease agreement would be structured, Hunt said, so that the city would get an upfront payment from the proceeds of those bonds.
Ratepayers would then see their water and sewer bills enlarged to cover the cost of debt servicing those bonds, paying for the water itself and the delivery of it through the system, and maintenance of the system. In addition, a percentage would be paid to the company doing the leasing to ensure its profit, along with the payment of fees to a law firm such as Hunt’s for drawing up the lease documents and serving as bond counsel, disclosure counsel and trustee counsel on the transaction.
Hunt said there are nearly 20 cities in Southern California that have used long-term leases of their water utility systems as a ploy of raising customer rates to generate money. By working with outside companies through such leasing structures, Hunt said, the companies profit, cities improve their financial situation, the water and sewer systems are maintained and the only ones who lose in the bargain are the ratepayers.
When queried if Upland could maintain its water and sewer systems without entering into  a lease, public works director Rosemary Hoerning said the city could do so by utilizing the money it currently takes in from its water customers to produce the water, distribute it and maintain the system, and that as costs to do so increase, the city can act as it has in the past by making rate adjustments to offset increases in operation costs and capital investments.
Hunt pushed the concept because his company, Norton Rose Fullbright, routinely participates in a variety of such arrangements involving municipalities and private companies in complex and sophisticated financial transactions, including acting as bond counsel and disclosure counsel to either governmental entities or serving as trustee’s counsel and developer’s counsel or representing national and regional investment banking firms in such municipal finance transactions.
Hunt’s effort to churn fees for Norton Rose Fullbright ran into some difficulty, however, when some members of the public in attendance at the workshop, alarmed at the fashion in which the presentation presumed upon the willingness of the city’s residents to accept city action that would see their water and sewer rates jump by as much as 500 percent by 2020, pressed Hunt on that issue. After two such inquiries in which he soft-pedaled, minimized or ignored the rate increase implications, he was confronted with a pointblank question as to whether the leasing of the water and sewer utility would entail rate increases and where the profit from the arbitrage arrangement would come from.
Hemmed in by the question, Hunt blurted, “It will come from the hides of the ratepayers.”
While Mayor Raymond Musser, who introduced Hunt at the beginning of the workshop, sought to remain above the fray, councilman Glen Bozar, who had to depart early to attend a water board meeting, enunciated his rejection of the leasing and arbitrage scheme before he left, stating that any move to create a joint powers authority to undertake a lease of the city’s water and sewer systems should be approved by the city’s residents through a vote before it is implemented. He said the city should not create an artificial entity to gouge the city’s residents on what they must pay for their water to pay off its unfunded pension liability.
Councilwoman Debra Stone said she was likewise skeptical of the concept.
Councilwoman Carol Timm would not embrace the leasing/arbitrage gambit either. “We shouldn’t outsource the management of the water just to get a cash benefit,” Timm said, saying there were “other alternatives… to improve infrastructure.”
Councilman Gino Filippi, however, endorsed the methodology Hunt outlined for generating money into municipal coffers, saying the need for more money “has nothing to do with the pension system.”
He said the infusion of money would be put to work to cover “day-to-day operations.” Something had to be done, Filippi said, because “Our [water] system is deteriorating.”
With Bozar absent, the council directed city manager Rod Butler to come back with more details on leasing management of the systems out, while instructing him to make other inquiries about other financial enhancement options, such as a sales or utility tax, bond measure or rate adjustments that would not entail transferring control of the water and sewer systems out of City Hall.