November 18, 2009 Loretta M. Leeson President, Board of School Directors BETHLEHEM AREA SCHOOL DISTRICT 1516 Sycamore Street Bethlehem, Pennsylvania 18017-6099 Dear Ms. Leeson: The Department of the Auditor General (―Department‖) has conducted a special investigation of the experience of the Bethlehem Area School District (―District‖) with Qualified Interest Rate Management Agreements (―QIRMAs‖). QIRMAs are ―swaps‖ and other types of derivatives that are purportedly designed to manage interest rate risk or interest cost in connection with the issuance of debt. From April 29, 2003 to June 27, 2006, the District entered into 13 different QIRMAs, the most of any school district in the Commonwealth of Pennsylvania. The District‘s 13 QIRMAs related to $272.9 million in debt. Our investigation found that the District‘s use of two QIRMAs associated with its variable-rate ―General Obligation Note, Series 2003 - West Cornwall Township Municipal Authority‖ (―2003 WCTMA Note‖) cost District taxpayers $10.2 million more than if the District had issued a standard fixed-rate bond or note, and $15.5 million more than if the District had simply paid the interest on the variable-rate note without any QIRMAs at all. The District‘s losses were largely due to excessive fees and other charges, especially a $12.3 million payment that the District had to pay to the investment bank counterparty to terminate one of the agreements. The 2003 WCTMA Note was the only one of the District‘s outstanding debt instruments as to which the ultimate cost to the District could be quantified. Because the District has other QIRMAs still in effect in connection with its other outstanding debt, the ultimate financial impact of the District‘s use of QIRMAs remains to be determined. The District appears to have complied with the applicable provisions of LGUDA as amended by Act 23 of 2003. However, we are concerned less by the District‘s compliance with state law with regard to entering into the QIRMAs at issue than by the propriety of governmental entities risking public funds via QIRMAs in the first place. It is important to recognize that the Bethlehem Area School District is not alone in its use of QIRMAs. Of the 500 school districts in the Commonwealth, 107 districts entered into at least one QIRMA during the period between October 2003 and June 2009. During the same period, 86 other local government units (―LGUs‖) entered into at least one QIRMA. According to data from the Pennsylvania Department of Community and Economic Development, there were 626 QIRMA filings made in Pennsylvania between October 2003 and June 2009, which related to $14.9 billion in debt. Therefore, while our investigation focused on the District‘s experience with QIRMAs, this report is equally applicable to all other school districts and LGUs across the Commonwealth that may have used such instruments. We have concluded that QIRMAs are highly risky and impenetrably complex transactions that, quite simply, amount to gambling with public money. Moreover, they are susceptible of being marketed deceptively, and they principally benefit the investment banks and the multitude of intermediaries who sell them to relatively unsophisticated public officials. Accordingly, we make the following recommendations: The use of QIRMAs and other derivatives by LGUs and municipal authorities should be prohibited by law; No LGU or municipal authority in this Commonwealth should enter into or utilize such instruments from this day forward; Any LGU or municipal authority in this Commonwealth that is a party to an active QIRMA should immediately terminate it and refinance with conventional debt instruments if necessary; and LGUs and municipal authorities should hire their financial advisors through a competitive selection process and periodically evaluate the quality, cost, and independence of the services provided. The Department will follow up at the appropriate time to determine the status of action on our recommendations. We are providing copies of this report to various governmental and independent entities that may have an interest in this matter for their review and whatever further action they may deem appropriate. In particular, we encourage the various law enforcement agencies that will receive this report to investigate and prosecute any conflicts of interest that were involved in these transactions. We also encourage them to pursue all available avenues to recover funds for the taxpayers of the District and other LGUs resulting from any and all breaches of fiduciary duty, including equitable relief from existing QIRMA obligations foisted on the LGUs by financial entities and advisors. We commend the District for its cooperation with this investigation and its positive response to the report. The District‘s response is included after the appendices, followed by the Department‘s comments on the response. This is a public report and its distribution is not limited. Additional copies may be obtained from the Department‘s website, www.auditorgen.state.pa.us. Sincerely, /S/ JACK WAGNER Auditor General TABLE OF CONTENTS Executive Summary ................................................................................................... 1 Background and Introduction .................................................................................... 4 Finding and Recommendations: Finding: The District‘s use of two QIRMAs associated with its variable- rate ―General Obligation Note, Series 2003 – West Cornwall Township Municipal Authority‖ cost District taxpayers $10.2 million more than if the District had issued a standard fixed-rate bond or note, and $15.5 million more than if the District had simply paid the interest on the variable-rate note without any QIRMAs at all.................................................................... 19 Conclusions and Recommendations .............................................................. 42 Appendices to Report: Appendix A: School Districts in PA that Entered into QIRMAs under Act 23 of 2003, Oct. 2003-June 2009 ............................... 48 Appendix B: Other Local Government Units in PA that Entered into QIRMAs under Act 23 of 2003, Oct. 2003-June 2009… . 52 Appendix C: Amendments to LGUDA favored by Steven J. Fishman, Chief Counsel of PA Dept. of Community & Economic Development ..................................................................... 55 Appendix D: Glossary of Terms Used in this Report ............................. 62 Bethlehem Area School District‘s Response to Draft Report ................................. 64 Department of the Auditor General‘s Comments on Bethlehem Area School District‘s Response to Draft Report ......................................................................... 66 Distribution List ....................................................................................................... 68 i EXECUTIVE SUMMARY The Department of the Auditor General (―Department‖) has conducted a special investigation of the use of Qualified Interest Rate Management Agreements (―QIRMAs‖) by the Bethlehem Area School District (―District‖), Lehigh/Northampton Counties, Pennsylvania. QIRMAs are ―swaps‖ and other types of derivatives that are purportedly designed to manage interest rate risk or interest cost in connection with the issuance of debt. From April 29, 2003 to June 27, 2006, the District entered into 13 different QIRMAs, the most of any school district in the Commonwealth of Pennsylvania. The District‘s 13 QIRMAs related to $272.9 million in debt. It is important to recognize that the Bethlehem Area School District is not alone in its use of QIRMAs. Of the 500 school districts in the Commonwealth, 107 districts entered into at least one QIRMA during the period between October 2003 and June 2009. During the same period, 86 other local government units (―LGUs‖) entered into at least one QIRMA. According to data from the Pennsylvania Department of Community and Economic Development, there were 626 QIRMA filings made in Pennsylvania between October 2003 and June 2009, which related to $14.9 billion in debt. Therefore, while our investigation focused on the District‘s experience with QIRMAs, this report is equally applicable to all other school districts and LGUs across the Commonwealth that may have used such instruments. We found the following with regard to the District’s use of QIRMAs: The District‘s use of two QIRMAs associated with its variable-rate ―General Obligation Note, Series 2003 - West Cornwall Township Municipal Authority‖1 (―2003 WCTMA Note‖) cost District taxpayers $10.2 million more than if the District had issued a standard fixed-rate bond or note, and $15.5 million more than if the District had simply paid the interest on the variable-rate note without any QIRMAs at all. The District‘s losses were largely due to excessive fees and other charges, especially a $12.3 million payment that the District had to pay to the investment bank counterparty to terminate one of the agreements. We were able to perform our analysis only on the 2003 WCTMA Note because it was the only one of the District‘s outstanding debt instruments as to which the ultimate cost to the District could be quantified. Because the District has other QIRMAs still in effect in connection with its other outstanding debt, the ultimate financial impact of the District‘s use of QIRMAs remains to be determined. Depending on future market fluctuations and other risk factors – which are inherently unpredictable -- and the District‘s reaction to them, the District‘s