School District Fiscal Oversight and Intervention

School District Fiscal Oversight and Intervention M A C TAy l o r • le g i s lA Ti v e A nAl y sT • A p r i l 3 0 , 2 012 An LAO RepOR t 2 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t ExEcutIvE Summary This report provides an overview and assessment of the state’s fiscal oversight system for school districts. The primary goal of this system is to ensure that school districts can meet their fiscal obligations and continue educating students. In recent years, the system has received considerable attention as the economic downturn has presented school districts with significant fiscal challenges. System Consists of Monitoring, Support, and Intervention. The fiscal oversight system established by the state in 1991 makes County Offices of Education (COEs) responsible for the fiscal oversight of all school districts residing in their county and requires them to review a school district’s financial condition at various points throughout the year. If a school district appears to be in fiscal distress, COEs, and in some instances the state, are granted various tools designed to help the district return to fiscal health. Fiscal Distress Often Linked to Unsustainable Local Bargaining Agreements and Declining Enrollment. School districts with several consecutive years of operating deficits tend to be the ones most likely to be experiencing fiscal distress. This is particularly the case when districts run deficits during good economic times, as these districts will have a smaller cushion to deal with unanticipated cost increases or funding reductions during an economic downturn. Prolonged deficit spending often is linked with unsustainable local bargaining agreements. Given employee costs are the largest component of a district’s budget, bargaining agreements that increase district costs at a faster rate than school district funding are particularly problematic. School districts with declining enrollment also are more likely to have fiscal problems, since the district’s funding typically will decrease at a faster rate than its costs and require reductions even during good economic times. Fiscal Oversight Process Begins With COE Review of Locally Adopted District Budget . . . To provide a consistent framework for assessing fiscal health, COEs use a state-established set of criteria and standards. The first point of review in the school year begins when the COE reviews the school district’s adopted budget. The COE determines whether the budget allows the school district to meet its financial obligations during the fiscal year. If the COE disapproves the school district’s budget, the school district must make modifications and resubmit the budget for approval. Disapproved budgets are a rare occurrence (on average only three budgets are disapproved per year), in part because school districts typically understand what is required to receive budget approval. . . . Continues as Districts Submit Interim Budget Reports at Subsequent Points in Fiscal Year. The COEs also must review the financial health of school districts at two points during the school year using updated revenue and expenditure estimates. These reviews are known as “first interim” and “second interim” reports. After reviewing a district’s report, the COE certifies whether the school district is at risk of failing to meet its obligations for the current year or two subsequent fiscal years. A district in good fiscal condition receives a positive certification. By comparison, a district that may be unable to meet its obligations in the current or either of the two subsequent fiscal years receives a qualified certification. A district that will be unable to meet its obligations in the current or subsequent fiscal year receives a negative certification. www.lao.ca.gov Legislative Analyst’s Office 3 An LAO RepOR t At Signs of Distress, COEs Authorized to Provide Support. When a school district is certified as qualified or negative, COEs may intervene in certain ways, including assigning a fiscal expert and requiring an update of the district’s cash flow and expenditure estimates. In addition, COEs must review any new collective bargaining agreements and approve the issuance of certain debt. School districts with these certifications also are required to submit a “third interim” report. If the above interventions do not improve the district’s fiscal condition, COEs can impose more intense interven- tions, including staying and rescinding actions of a school district’s local governing board. If District Cannot Meet Obligations, State Provides Emergency Loan and Takes Administrative Control. When a school district is unable to meet its financial obligations, the state provides it with an emergency General Fund loan. The school district then works with the state’s Infrastructure and Economic Development Bank to issue bonds to repay the initial state loan. The district is responsible for paying the debt service and issuance costs of the loan as well as the salaries of various employees hired to provide administrative assistance to the district. From a governance perspective, the state Superintendent of Public Instruction (SPI) assumes all of the duties and powers of the local board and appoints a state administrator to act on his or her behalf. The primary goal of the state administrator is to restore the fiscal solvency of the school district as soon as possible. When the SPI and state administrator determine that the district meets certain performance standards and is likely to comply with its recovery plan, the local governing board regains control of the district and the state administrator departs. Until the loan is repaid in full, a state trustee with stay and rescind powers is assigned to oversee the district. System of Oversight and Intervention Generally Has Been Effective. Over the last two decades, the state’s fiscal oversight system has reduced the number of school districts requiring state assis- tance and has provided oversight and support while still primarily maintaining local authority. During the more than 20 years the new system has been in effect, eight districts have received emergency state loans. By comparison, 26 districts required such loans in the 12 years prior to the new system. Furthermore, to this point, no school district has required an emergency loan as a result of the recent recession and associated budget reductions. Additionally, while the number of districts with qualified and negative budget certifications has increased in recent years, the state has not seen a corresponding increase in the number of emergency loans required. This suggests the system’s structure of support and intervention is serving a critical early warning function—allowing districts to get the help they need while fiscal problems tend to be smaller and more manageable. Recommend Preserving System Moving Forward. Despite the system’s effectiveness, state actions over the last three budget cycles temporarily have reduced the ability of COEs to identify districts on the road toward fiscal distress. Most notably, the state adopted legislation that prevented COEs from disapproving 2011-12 budgets if districts appeared unable to meet their financial obliga- tions for the following two fiscal years. We recommend the state avoid additional actions that would diminish its ability to assess school district fiscal health, provide support for fiscally unhealthy school districts, and prevent the need for emergency loans. Although proper fiscal oversight is important at any time, it is particularly important in years during and following an economic recession, when districts are more likely to experience fiscal distress. 4 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t IntrODuctIOn In 1991, the state established a comprehensive Despite the relatively longstanding success of the system for monitoring the fiscal condition of system in helping to maintain good school district school districts. Under this system, COEs review fiscal health, the state recently has taken certain their school districts’ fiscal conditions shortly after actions that have temporarily reduced the system’s districts adopt their budgets and then at a few effectiveness. These recent actions generally have subsequent points in the fiscal year. School districts reduced the ability of COEs to identify fiscal that show signs of fiscal distress receive assistance, problems looming on the horizon for districts. with the type and amount of assistance depending Especially in difficult, uncertain budget times, on the gravity of a district’s fiscal condition. In a system of monitoring and supporting school the most serious case—when a district no longer district fiscal health is paramount. As the state appears able to meet its financial obligations—the considers future actions, we recommend that it state provides it with an emergency loan and remain focused on preserving the system. assumes administrative control until the district Below, we identify the common problems that has demonstrated clearly that it is solidly on the characterize fiscally unhealthy districts. We then road to fiscal recovery. summarize the oversight process for evaluating During the two decades this system has been school district fiscal health. Next, we describe the in place, school districts have faced numerous fiscal first- and second-level interventions designed to challenges. Particularly through the economic assist fiscally unhealthy school districts as well as downturns, the system has proven to be generally describe the emergency loan process for districts that effective at identifying districts experiencing fiscal are unable to meet their financial obligations. Finally, distress and providing them targeted support. we provide our assessment of the existing system. SIgnS OF FIScal DIStrESS A number of common problems tend to operating deficits during good economic times. be found in fiscally unhealthy districts. The These districts will have a smaller cushion to deal Fiscal Crisis and Management Assistance Team with unanticipated cost increases or reductions in (FCMAT)—the state agency that provides fiscal funding during an economic downturn. advice, management assistance, and other training Deficit Spending Commonly Linked With to school districts—identified 15 conditions that Unsustainable Local Bargaining Agreements and most frequently indicate district fiscal distress. These Declining Enrollment. Since employee salary and conditions are listed in Figure 1 (see next page). benefit costs typically represent about 85 percent Fiscal Distress Often Linked With Multiple of school district expenditures, the terms of a Years of Deficit Spending. School districts with school district’s collective bargaining agreements several consecutive years of operating deficits likely have a significant effect on its fiscal health. Local have many of the indicators of fiscal distress listed bargaining agreements that increase district costs in Figure 1 and tend to be most at risk for failing to at a faster rate than school district funding are meet their financial obligations in the near future. particularly problematic, as the district will be This is particularly true of school districts that run more likely to run operating deficits during these www.lao.ca.gov Legislative Analyst’s Office 5 An LAO RepOR t times. School districts with declining enrollment state loan since 2000, four had experienced flat or also are more likely to have fiscal problems, since declining enrollment in the years prior to receiving their revenues tend to decline at a faster rate than state intervention. their costs. Because of this fiscal pressure, declining More Recently, Payment Deferrals and Budget enrollment districts must be proactive in reducing Reductions Contributing to Fiscal Distress. Over costs during good fiscal times when other districts the past several years, school districts have faced in the state are providing cost-of-living increases increased fiscal pressure as a result of funding to employees and expanding the size of their reductions implemented to solve the state’s budget programs. School districts that do not make suffi- problem. Since 2007-08, the year prior to the cient reductions to address the decline in funding economic downturn, state programmatic per-pupil can experience significant fiscal distress. Of the five funding for school districts has decreased by school districts that have received an emergency 8 percent. The state also has relied significantly on Figure 1 Fifteen Key Predictors of School District Fiscal Distress Administrative Issues 9 Governance crisis 9 Lack of communication with educational community 9 Lack of interagency cooperation 9 Failure to recognize ongoing budget problems 9 Disconnect between personnel data and payroll 9 Limited access to timely personnel, payroll, and budget control data and reports 9 Lack of routine categorical program monitoring Financial Issues 9 Unsustainable collective bargaining agreements 9 Compensation increases in excess of state funding increases 9 Failure to maintain healthy reserves 9 Flawed multiyear projections 9 Flawed average daily attendance projections 9 Inaccurate revenue and expenditure estimates 9 Poor cash flow analysis and reconciliation 9 Categorical program increases in excess of categorical funding increases 6 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t payment deferrals as a budget solution over the of these additional challenges, school districts past several years, with school districts currently have had to make significant adjustments to their receiving $9.4 billion (roughly 20 percent of budgets, including reducing their educational Proposition 98 funding) in late state payments (that programs and borrowing to meet their financial is, receiving cash in 2012-13 for costs incurred in commitments. 2011-12). To remain in good fiscal health as a result FIScal OvErSIght PrOcESS Under the state’s fiscal oversight process, a • Operating deficits. school district’s COE is responsible for monitoring • Accuracy of attendance and enrollment its fiscal health at specific points during the year. estimates. At the beginning of the fiscal year, the COE must review and approve the school district’s locally • Accuracy of revenue limit funding adopted budget. The district also must submit estimates. up-to-date multiyear projections for the COE to review at two subsequent points during the year. • Salary and benefit costs. (A third interim report also is required for school • Facility maintenance costs. districts that show signs of fiscal distress.) In addition to these formal points of review, COEs seek Each criterion has a specific standard that is to remain in constant contact with school district used for evaluation of a school district’s financial superintendents, administrators, and business condition. School districts, for example, are officers. In our conversations with COE officials expected to have reserves of at least 1 percent throughout the state, we found that virtually all to 5 percent depending on the size of the have monthly meetings with school district staff to district (smaller districts having higher reserve remain informed of each district’s fiscal condition. requirements). We discuss the details of the formal oversight Budget adoption process below. In accordance with state law, the local criteria and Standards for review governing board of a school district must adopt To provide a consistent framework, COEs must a budget in a public hearing by July 1 every year. use a consistent set of criteria and standards estab- The school district’s budget must be reviewed by lished by the state to assess school districts’ fiscal the COE by August 15. Though the main objective condition. These criteria and standards are used of the COE is to determine whether the budget both to review school districts’ adopted budgets allows the school district to meet its financial and their interim budget reports. The specific obligations during the coming fiscal year, the COE criteria and standards used vary depending on also examines whether the district’s budget plan the specific point of review. Each review, however, would enable it to satisfy its financial commitments focuses on the following major criteria: in future years. The COE also must determine whether the district complies with the existing • Fund and cash balances. criteria and standards. The district is required to • Reserve levels. www.lao.ca.gov Legislative Analyst’s Office 7 An LAO RepOR t submit to the COE any studies, reports, evalu- merit disapproval of the district’s budget. ations, or audits that show evidence the school If the committee rules in favor of the district is under fiscal distress or exhibits at least district, the school district can implement 3 of the 15 indicators of fiscal distress listed in its budget plan without modifications. If Figure 1. After reviewing the budget, the COE takes the committee rules in favor of the COE, one of the following actions: the district must submit modifications to the SPI for approval. If the SPI rejects the • Approves Budget. The COE approves the district’s revised budget plan, the COE can district’s budget plan. No further action is implement a budget plan for the district. needed. Budget Review Provides Feedback for All • Conditionally Approves Budget. The Districts. Even when the COE approves a district’s COE approves the budget plan but has budget plan, the COE review can provide useful concerns about the district’s ability to feedback and point out key areas that merit the meet its financial obligations. The COE district’s attention. For example, the COE may must provide a rationale for its conditional point out that more accurate estimates of the school approval and recommend revisions the district’s annual enrollment would help prevent district can take to improve its budget inadvertent deficit spending in future years. Such an situation. The COE also can assign a fiscal analysis gives the district additional information on advisor to help the school district make the specific issues that the COE thinks are important revisions to the budget plan. The district, in ensuring the long-term fiscal health of the district. however, is not required to take specific Disapproved Budgets Are Rare. Given the action to address the concerns of the COE constant communication between districts and or fiscal advisor. COEs, school districts typically have a clear • Disapproves Budget. The COE can disap- understanding of the actions they must take to prove a district’s budget if it determines have their budget plans approved by the COE. As a the district cannot meet its financial result, a disapproved budget is rare. Since 1991-92, obligations under the adopted plan. In an average of three school districts have had their response to a disapproved budget, the budgets disapproved each year (less than 1 percent district must hold a hearing and publicly of all districts). A Budget Review Committee also release the COE’s recommended changes. is a very rare occurrence. Roughly seven of eight The district also must make modifications districts with disapproved budgets resolved the and resubmit the budget to the COE for issue working directly with their COE. review. If the COE disapproves the budget Interim reporting a second time, a Budget Review Committee can be established to resolve the issue. After reviewing a school district’s adopted (The committee consists of three members budget, COEs review the financial health of school who are chosen by the school district districts at two points during the school year. The from a list of candidates provided by the information required and report due dates are SPI.) The committee reviews the COE’s shown in Figure 2. By December 15, school districts concerns and determines whether they must provide COEs with a financial report based on revenue and expenditure data as of October 31. 8 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t Figure 2 School District Reporting Time Lines Oct 31 Dec 15 Report First Interim Data Due Jan 31 Mar 15 Report Second Interim Data Due Apr 30 Jun 1 Report Third Interim Dataa Due Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun a Third interim reports only required for districts with a qualified or negative certification. By March 15, districts must provide a financial (see next page) shows the number of qualified report based on data as of January 31. These reports and negative (“at-risk”) districts each year since are known as first interim and second interim. 1991-92. As the figure shows, the number of Districts must provide COEs with an interim districts with such certifications significantly report that includes revenue and expenditure increased beginning in 2007-08. The year with estimates for the current year and two subsequent the most at-risk districts was in 2009-10, the fiscal years. The COE reviews each district’s report first full year following major state reductions in and uses the criteria and standards to place districts education funding. Given certifications are based into one of the following three categories: on the district’s fiscal condition in the current and two subsequent fiscal years, assumptions about • Positive Certification. Will meet obliga- future funding have a significant effect on a school tions for current and two subsequent years. district’s certification. The basis for assessing • Qualified Certification. May not meet second interim reports (submitted based on data as financial obligations for current or either of of January 31) is the Governor’s January 10 budget the two subsequent fiscal years. proposal. If the Governor’s budget proposes to make significant budget reductions, districts are • Negative Certification. Will be unable to more likely to be certified as negative or qualified meet financial obligations for current or if they do not have a plan for implementing the subsequent fiscal year. Governor’s proposed reductions. Highest Number of Qualified and Negative Certifications in 2009-10 and 2010-11. Figure 3 www.lao.ca.gov Legislative Analyst’s Office 9 An LAO RepOR t Figure 3 Number of At-Risk Districts Has Increased in Recent Years 200 Negative Districts Qualified Districts 180 160 140 120 100 80 60 40 20 91-92 93-94 95-96 97-98 99-00 01-02 03-04 05-06 07-08 09-10 FIrSt lEvEl OF IntErvEntIOn FOr at-rISk DIStrIctS The oversight process is designed to address further understanding of the district’s financial the school district’s fiscal problems with the least condition and help the district develop a plan for amount of intervention possible. When a district is returning to fiscal health. Under state law, the COE certified as qualified or negative during the interim must take at least one of the following actions: reporting process, the state’s fiscal oversight system • Assign a Fiscal Expert. The COE can provides COEs with certain tools to assist school appoint a fiscal expert, at no cost to the districts as well as creates additional reporting district, to help the district improve its fiscal requirements for these districts. Existing law also health. Fiscal experts tend to be former allows COEs to use these tools if a school district school district superintendents or chief received a positive certification but now appears business officers with significant experience unable to meet its financial obligations. These tools in school district fiscal issues. The expert, and additional reporting requirements are shown however, has no formal authority to impose in Figure 4. his or her recommendations. The school district governing board still maintains all tools to assist School Districts authority to make the necessary changes to When a school district is certified as qualified improve the district’s fiscal health. Based on or negative, the COE will take action to develop our discussions with COE staff, assigning 10 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t Figure 4 Intervention for At-Risk Districts First-Level Intervention for Qualified and Negative Districts COEs Must Do at Least One of the Following: • Assign a fiscal expert. • Conduct a study of the district’s financial condition. • Require a report of the district’s financial projections. • Require an update of cash flow and expenditure estimates. • Require that the district submit a proposal to address its fiscal health. • Assign FCMAT to review the district’s management of the teacher workforce. • Withhold compensation from the district superintendent or governing board members if they do not provide all requested information. Reporting and Review for All At-Risk Districts: • “Third interim” report due June 30. • COE must review and comment on proposed collective bargaining agreements. • COE must approve issuance of certain debt. • District may be subject to audit or review by State Controller. Second-Level Intervention for Negative Districts COEs Must Do at Least One of the Following: • Assign a fiscal advisor.a • Develop and impose budget revisions in consultation with SPI and local governing board. • Stay or rescind local governing board action. • Assist in developing budget or financial plan. a The fiscal advisor can implement the other second-level actions on behalf of the COE. COEs = County Offices of Education; FCMAT = Fiscal Crisis and Management Assistance Team; and SPI = Superintendent of Public Instruction. a fiscal expert is common, particularly for require the district to revise its financial school districts with a negative certification. documents to ensure that information is accurate and based on the latest infor- • Conduct a Study of Financial Condition. mation. Specifically, the COE can require The COE can conduct a study of the school the district to review its accounting of district’s financial condition to develop existing contracts and financial transac- a more thorough understanding of the tions, update its cash flow analyses, and school district’s financial problems. The resubmit its monthly or quarterly budget study must include a review of the internal revisions. controls currently in place to manage district expenditures. • Require District Submit Proposal to Address Fiscal Health. The COE can • Require Report of Financial Projections. direct the district to submit a proposal that To develop a greater understanding of the would address the primary fiscal issues district’s finances, the COE can require the that caused the district to be certified as district to submit financial projections of qualified or negative. all fund and cash balances for the current and subsequent fiscal years. • Assign FCMAT to Review Teacher Workforce Issues. The COE can • Require Update of Cash Flow and assign FCMAT to study and provide Expenditure Estimates. The COE can www.lao.ca.gov Legislative Analyst’s Office 11 An LAO RepOR t recommendations to streamline and COE necessary to assess the cost of the collective improve the district’s teacher hiring bargaining agreement and list any budget revisions process, teacher retention rate, extent of that the school district must make to have sufficient teacher misassignments, and supply of funds to fulfill the agreement. If the school district highly qualified teachers. does not make these revisions, it will receive a qualified or negative certification in the subsequent • Withhold Compensation. The COE interim report. can withhold the compensation of the COE Approval to Issue Certain Debt. Prior district superintendent or governing to issuing non-voter approved debt, a qualified or board members if they fail to provide all negative school district must obtain a determi- requested financial information. nation from the COE that the district would likely be able to repay the debt. School districts issue additional Oversight for all at-risk Districts non-voter approved debt for a number or reasons. In addition to the above corrective actions For example, many districts issue certificates of that COEs can take, qualified and negative school participation to finance facility projects or issue tax districts are subject to additional requirements for and revenue anticipation notes to meet their cash reporting and review. These requirements ensure flow needs. The COE determination provides an that the COE is aware of any changes to a district’s additional layer of oversight to ensure that school fiscal condition that would require further inter- districts do not issue debt that is unlikely to be vention or support. repaid. The COE also must issue the determination Third Interim Reporting. A school district for non-voter approved debt in the year following certified as qualified or negative at second interim the negative or qualified certification, even if the is required to submit a third interim report by district has a positive certification. June 1. This report must be based on information Possible Controller Audit or Review. When a through April 30. Third interim reports provide a district is qualified or negative, the State Controller COE with additional information to ensure that has the authority to audit or review the fiscal the school district’s fiscal condition has not signifi- condition of the district at any time during the year. cantly deteriorated during the subsequent months The controller, however, rarely exercises this authority. since the second interim report. cOEs can Intervene in Some Districts COE Review of New Collective Bargaining With Positive certification Agreements. Prior to approving any new collective bargaining agreement, qualified or negative school The COE’s assessment of a school district’s districts must allow the COE at least ten working financial condition can change shortly after major days to review and comment on whether the reporting periods, as the school district updates proposed agreement would endanger the fiscal its revenue and expenditure estimates based on health of the district. The COE notifies the school the latest data. In some cases, a school district district governing board, school district superin- with a positive certification may be at risk of not tendent, and all parent and teacher organizations meeting its financial obligations due to changes in within ten days if the agreement would endanger its revenue or expenditure estimates. If a COE finds the fiscal well-being of the district. The school that a district with positive certification would district is required to provide all information to the be classified as qualified or negative using more 12 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t up-to-date information, existing law allows COEs assist any district whose fiscal situation has deterio- to use the same tools that can be used for qualified rated after interim reporting was completed. or negative districts. This ensures the COE can SEcOnD lEvEl OF IntErvEntIOn FOr nEgatIvE DIStrIctS If a district’s fiscal condition has not improved and cannot conflict with the school district’s after the initial level of intervention, the existing existing collective bargaining agreements. fiscal oversight system allows COEs to impose more Because the revision must be developed in intense interventions if a district has a negative consultation with the school district and certification (or if the district has a positive certi- cannot change the terms of any collective fication but is later deemed to be unable to meet bargaining agreements, COEs rarely impose its obligations in the current or subsequent fiscal budget revisions. year, the equivalent of a negative certification). • Stay or Rescind District Actions. The In these cases, the COE must notify the school COE can stay or rescind any action taken district governing board, the school district by the local governing board of the school superintendent, the SPI, and all parent and teacher district if the COE finds that the district organizations in the district that the school district would be unable to meet its financial still appears unable to meet its financial obliga- obligations as a result of the action. For tions. In the notification, the COE must include example, the COE can rescind the district its assumptions in making the determination. As governing board’s approval of a new or Figure 4 shows, the COE then must take at least revised collective bargaining agreement if one of the following actions: the COE finds the district could not afford • Assign Fiscal Advisor. The COE can the agreement. Of the powers granted to assign a fiscal advisor to assist the school the COE to assist districts with negative district. The fiscal advisor can take the certification, stay-and-rescind authority is actions listed below on the COE’s behalf. the strongest. Because COEs may exercise this additional authority and overturn the • Develop and Impose Budget Revisions. actions of the local governing boards, local The COE can develop and impose a budget boards presumably have greater incentive revision, in consultation with the school not to take any action that could result in district and SPI, to ensure the district will be the districts being unable to meet their able to meet its financial obligations in the financial obligations in the future. current fiscal year. The school district can appeal the revision to the SPI if it finds the • Assist in Developing Budget or Financial revision unnecessary or believes the revision Plan. The COE can help the school district is larger than necessary for the district to develop a multiyear budget or financial be able to meet its financial obligations. The plan to enable the district to meet its future revision cannot violate state or federal law obligations. www.lao.ca.gov Legislative Analyst’s Office 13 An LAO RepOR t thE ultImatE IntErvEntIOn: EmErgEncy lOan anD StatE takEOvEr When a school district is unable to meet its of the Legislature and notify them that emergency financial obligations, the state will intervene to legislation may be necessary for the district to ensure the school district continues to provide remain solvent. Because the process of securing educational services for its students. In these an emergency loan typically takes several months, cases, a number of actions are taken to prepare the district and COE must act early to ensure the the school district for an emergency loan, process district has cash available to meet its monthly the emergency loan, and transfer administrative obligations, such as payroll and utility costs. control of the district to the state. This process can Prior to receiving the loan, however, the district result in significant changes to the governance and must develop a plan for improving its financial finances of a school district. Figure 5 summarizes condition and have the plan approved by the COE the various changes that occur with an emergency and submitted to the SPI, the Legislature, the loan and state takeover. Department of Finance, and State Controller. Cash Flow Ultimately Determines a District’s Financial Effects Need for Emergency Loan. Whereas a school district’s return to fiscal health is primarily deter- Emergency Loan Must Be Provided by mined by taking action to avoid deficit spending Legislation. For a district to secure an emergency in future years, lack of available cash is the most state loan, the Legislature must adopt authorizing important factor that results in a district needing legislation. The legislation typically is carried by a an emergency loan. School districts can continue legislator who represents the Assembly or Senate to run deficits and meet their financial obliga- district in which the school district resides. The tions if they have sufficient cash reserves or can legislation provides a direct General Fund appro- borrow from external sources. As the district’s priation to the school district. This appropriation is fiscal condition deteriorates, however, the district’s only intended to serve as short-term financing until reserve levels decrease and lenders become less the school district secures another loan that will willing to provide cash to the school district. provide longer-term financing. Eventually, if no steps are taken to improve the District Finances Loan Using Bonds. Until district’s condition, the district will be unable to 2004, the state provided emergency loans to school borrow and will need an emergency loan. districts with General Fund monies at relatively low Districts Prepares for Emergency Loan. If interest rates. In that year, however, the state passed the school district appears unable to make the Chapter 263, Statutes of 2004 (AB 1554, Keene), necessary adjustments to meet its financial obliga- which required districts to obtain funding by tions, the district (often in coordination with the selling bonds to private investors through the state’s COE) must take immediate action to notify state Infrastructure and Economic Development Bank officials and the public. The COE or FCMAT (I-Bank). The legislation was intended to relieve staff may attend a meeting of the school district the General Fund from the burden of financing governing board to discuss the consequences of school district emergency loans in the event that receiving an emergency loan from the state. School several large school districts were unable to meet district or COE staff also may contact members their financial obligations. Under the Chapter 263 14 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t system, the I-Bank issues bonds on behalf of the Figure 5 district to finance the Emergency Loan and State Takeover Process emergency loan. The process of developing and District notifies SPI selling bonds can take and Legislature about need for loan. several months. Once the bonds are issued, Legislature adopts bill the district uses part of Governancea to authorize loan. Finance the proceeds to repay the state’s General Fund SPI assumes legal duties of State provides short-term appropriation and uses school board. School board General Fund loan. becomes advisory. the remaining funds to I-Bank sells bonds to investors pay its obligations. Funds SPI appoints state on district's behalf. administrator to act on its to make debt service behalf. District repays state with bond payments are intercepted District superintendent is fired. proceeds. from the school district’s revenue limit funding. State administrator implements District makes debt service plan to return district to payments to investors for District Bears Costs solvency. 20 years. of Loan and Oversight. School board can regain control in certain areas with School districts are SPI approval. responsible for paying the School board regains full interest and issuance costs control with SPI approval. State administrator departs. of the bonds, typically over a 20-year period. State trustee oversees district until loan is repaid. Trustee (Issuance costs tend to retains stay-and-rescind authority. be fixed costs that do not a If the size of a district’s emergency loan is less than 200 percent of its recommended reserve levels, vary significantly with the then a state administrator is not appointed. Instead, a state trustee with stay-and-rescind authority is appointed to oversee the district until the loan is repaid. size of a loan.) The school SPI = Superintendent of Public Instruction; and I-Bank = Infrastructure and Economic Development Bank. district also must pay for the salaries of fiscal (typically about 6 percent of total expenditures), the experts, state adminis- governing board loses its authority over the admin- trators, trustees, auditors, and other employees who istration of the school district. The SPI assumes have been hired to provide assistance to the district. all of the duties and powers of the local board The loan amount is intended to provide the district and appoints a state administrator to act on his or with sufficient funds to meet all these obligations. her behalf. The local board serves as an informal changes in governance advisor to the state administrator and does not receive any form of compensation from the district. Local Governing Board Loses All Authority. If State law also requires that the district superin- the emergency loan received by the district is more tendent no longer be employed by the district. than 200 percent of its recommended reserve levels www.lao.ca.gov Legislative Analyst’s Office 15 An LAO RepOR t Existing Contracts and Obligations Remain. in all five areas and the state administrator deter- The primary goal of the state administrator is to mines that the district is likely to comply with its restore the fiscal solvency of the school district as recovery plan, the local board regains control of soon as possible. In achieving this goal, the state the district and the administrator leaves. Until the administrator is to develop a budget and financial loan is repaid in full, however, a state trustee with plan for restoring the school district’s fiscal health. stay-and-rescind powers is assigned to oversee The state administrator, however, is not granted the district. In practice, the state administrator any additional powers to change existing collective typically maintains control for several years before bargaining agreements or other contracts entered the local board regains its powers. into by the school district. These agreements must If Loan Is Small, State Trustee Is Appointed. If be renegotiated with interested parties. the emergency loan received by the district is less than Authority Returns to Local Governing 200 percent of its recommended reserve levels, then a Board After Careful Review. While the state state trustee is appointed to oversee the school district. administrator is in control, the SPI and FCMAT Although the local governing board retains its legal are to develop standards and expectations for the authority over the district, the state trustee has the district’s performance in five key areas: (1) financial power to stay or rescind any action of the local board management, (2) pupil achievement, (3) personnel that would have a negative effect on the financial management, (4) facilities management, and condition of the school district. The state trustee is (5) community relations. The district can regain removed when the district repays the emergency loan power in any of these areas if it meets these and the SPI determines that the district is likely to standards. When the district meets the standards follow the fiscal plan approved by the COE. aSSESSmEnt OF SyStEm Given the substantial fiscal challenges that Existing System generally has Been Effective school districts have faced over the last two Fewer Districts Have Received Loans Since decades, the state’s fiscal oversight system has been the Implementation of Existing System. Since the effective in ensuring that school districts remain implementation of the current oversight system fiscally healthy. The system appears to have reduced in 1991, fewer school districts have required the number of school districts requiring state assis- emergency loans from the state to meet their tance and has provided oversight and support while financial obligations. From 1979 to 1991, 26 school still allowing school districts to have final decision- districts received emergency appropriations from making authority in most cases. Although the the state. As Figure 6 shows, eight districts have oversight process appears to be very effective, we received emergency loans in the 20 years since the have some concerns with the cost school districts new system was adopted. must bear for an emergency state loan. Nonetheless, No School Districts Have Required an other permanent, lower cost options likely do not Emergency Loan Since Start of Recent Recession. exist. For example, financing these loans through Despite the fiscal challenges and uncertainty faced the state General Fund likely is not feasible when by school districts following the recent economic the state’s overall budget condition or short-term downturn, no school district to this point has cash flow situation is poor. 16 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t required an emergency loan as a result of recent shows, King City Joint Union High School District budget reductions. King City Joint Union High (King City High), the only district that has received School District, the last school district to receive an emergency loan under the new system estab- an emergency loan, required a loan based on fiscal lished in Chapter 263, currently pays 5.44 percent problems that were in place prior to major budget interest for its emergency loan. By contrast, reductions in 2009. Oakland and Vallejo unified school districts have System Works While Largely Maintaining interest rates of less than 2 percent. The higher rate District Authority. The fiscal oversight system has paid by King City High will increase significantly been effective in preventing insolvency without the district’s debt service costs and thus require a significantly interfering with the actions of school reduction in the size of its educational programs district governing boards. The system’s focus on until the loan is paid off. Annual debt service costs interim reporting and communication between the for the district are $1.2 million, roughly 9 percent COE and school district ensure that school districts of its unrestricted general purpose revenue in understand the major issues that must be addressed 2010-11. Additionally, unlike prior emergency loans to obtain budget approval or a positive certification that were provided through the state General Fund, from the COE. Moreover, in most cases, major King City High would face significant pre-payment solutions to district fiscal challenges still ultimately penalties if it repaid its loan in full ahead of are made by school district governing boards and schedule. As a result, few options are available for not by the COE or SPI. the district to reduce the financial burden of the emergency loan over the next 20 years. Emergency loan Is costly for Districts, State General Fund Cannot Support Large But Better Options unlikely to Exist Loans. Despite the significant costs to school Emergency Loan Carries High Costs. districts, the state has limited ability to assist Particularly as a result of changes implemented by school districts given its ongoing cash management Chapter 263, districts that receive an emergency problems. Although these loans may not be a loan can face a significant financial burden over the significant burden when a small district requires a 20 years in which their loan is repaid. As Figure 6 loan, the state could face a significant cash problem Figure 6 Emergency Loans to School Districts Since 1991 (Dollars in Millions) Year of Current Total Interest Pay-Off School District Legislation State Involvement Loan Amount Rate on Loana Date of Loan King City Joint Union Highb 2009 Administrator $13.0 5.44% October 2028 Vallejo City Unified 2004 Trustee 60.0 1.50 January 2024 Oakland Unified 2003 Trustee 100.0 1.78 January 2023 West Fresno Elementary 2003 None 1.3 1.93 December 2010 Emery Unified 2001 None 1.3 4.19 June 2011 Compton Unified 1993 None 20.0 4.39 June 2001 Coachella Valley Unified 1992 None 7.3 5.34 December 2001 West Contra Costa Unified 1991 None 29.0 1.53 January 2018 a For districts with multiple loans and multiple interest rates, reflects interest rate on largest loan. b Has since changed its name to South Monterey County Joint Union High. www.lao.ca.gov Legislative Analyst’s Office 17 An LAO RepOR t if it was required to provide General Fund loans the ability of COEs to use existing tools to monitor for large school districts or for a sizeable number of and assist at-risk districts. Given the oversight school districts in the same year. process is crucial to identifying districts that may need additional support and assistance, these types Preserving System critical of actions both reduce the amount of information Given the effectiveness of the existing oversight available to the state and reduce the tools available and intervention system, we think preserving the for COEs to assist school districts. existing system is critical for ensuring that suffi- Avoiding an Emergency Loan Is Vital for cient support exists to prevent additional districts District Fiscal Health. Given the substantial from requiring an emergency loan. disruption and burden caused by districts going to Oversight Process Somewhat Weakened the brink of insolvency, the state should continue by Recent Budget Actions. The fiscal oversight to prioritize the monitoring of school districts to system is especially crucial during challenging prevent as many as possible from requiring an fiscal times, when school districts often must deal emergency loan. The significant costs incurred with uncertain revenues, large state deferrals, and by school districts as a result of the loan further possible trigger reductions. Over the past several deteriorates their financial condition and reduces years, however, the state has taken one-time the amount of funding available for core educa- actions that have reduced the ability of COEs to tional programs. disapprove district budgets or certify districts as Oversight Especially Critical in Fiscally qualified or negative. Beginning in 2009, the state Challenging Environment. An effective state fiscal reduced the minimum reserve requirements for oversight system will help school districts remain school districts to one-third of their existing levels fiscally healthy, retain local control, and avoid in 2009-10, 2010-11, and 2011-12, making it more significant debt obligations over a 20-year period. difficult for COEs to raise concerns with districts Although proper fiscal oversight is important that were carrying low reserve levels. Perhaps of at any time, an effective system is particularly even greater concern, in the 2011-12 Budget Act, important in years during and following an the state adopted legislation that prevented COEs economic recession, when districts are more from disapproving 2011-12 school district budgets likely to experience fiscal distress. Given the fiscal if the district appeared unable to meet its financial challenges school districts have faced in recent obligations for the following two fiscal years. The years and the uncertainty of state funding in future 2011-12 Budget Act also required school districts years, the state oversight system is and will remain to assume the same level of per-pupil funding in a critical tool for monitoring the fiscal health of 2011-12 as they received in 2010-11, essentially school districts and determining whether districts requiring COEs to ignore proposed trigger reduc- require additional support to meet their financial tions when reviewing school district budgets. These obligations and maintain their educational changes to the existing oversight system reduced programs. 18 Legislative Analyst’s Office www.lao.ca.gov An LAO RepOR t cOncluSIOn Our review indicates that the oversight system Given the system has proven to be generally established in 1991 has been effective in preserving effective over the last two decades—during both school district fiscal health and helping school good and bad economic times—we recommend districts avoid emergency loans. Most notably, the system be preserved. In recent years, however, during the more than 20 years the new system has certain state actions temporarily have reduced been in effect, 8 districts have received emergency the system’s effectiveness. In particular, in the last state loans whereas 26 districts required such three years, the state temporarily has reduced the loans in the 12 years prior to the new system. ability of COEs to identify districts on the road Additionally, under the new system, the number of toward fiscal distress and provide these districts districts with qualified and negative budget certi- with additional oversight and assistance. Moving fications has increased in tight budget times, but forward, we caution the state against adopting these without a corresponding increase in the number types of actions. As districts continue to struggle of emergency loans required. This suggests the in the aftermath of the recent recession, we believe system’s structure of support and intervention is preserving the existing oversight system is vital for serving a critical early warning function—allowing fostering the ongoing fiscal well-being of districts. districts to get the help they need while fiscal problems tend to be smaller and more manageable. www.lao.ca.gov Legislative Analyst’s Office 19 An LAO RepOR t laO Publications This report was prepared by edgar Cabral and reviewed by Jennifer Kuhn. The legislative Analyst’s office (lAo) is a nonpartisan office that provides fiscal and policy information and advice to the legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the lAo’s website at www.lao.ca.gov. The lAo is located at 925 l street, suite 1000, sacramento, CA 95814. 20 Legislative Analyst’s Office www.lao.ca.gov