By Douglas J. Hajek

Community banks from time-to-time are called upon to finance public improvements or equipment needs – streets, schools, fire stations, courthouses, to name but a few. Nonprofit organizations (hospitals and nursing homes, for example) also need financing, and often do so using a local unit of government as the conduit as a means to reduce financing costs. While community banks desire to help with these financings, they must be aware of certain requirements.

Whether the financing instrument is called a bond, note, certificate of participation, or something else, our state statutes will generally include it under the definition of “bond.” As such, the obligation must be issued strictly in accordance with South Dakota constitutional and statutory requirements, and federal tax laws and regulations. Failure to observe these requirements – including constitutional debt limits, procedural requirements for authorization, elections (when required), tax filings, and other formalities – can affect the validity of the bond and whether the interest it bears will be exempt from federal income tax. (Even if the interest is exempt from federal income tax, it will not be exempt from the South Dakota bank franchise tax.)

In addition to confirming the bond’s interest will be tax-exempt, whenever possible the bank will want the issue to be “bank-qualified” — that is, formally designated by the bond issuer as a “qualified tax-exempt obligation.”  This designation is available for certain tax-exempt obligations issued by qualified small issuers that reasonably anticipate issuing no more than $10 million in tax-exempt obligations during the calendar year in which the bond is issued.  Generally, if the bond has been so designated, the bank may deduct 80% of its interest expense allocable to funding the investment.  Otherwise, disallowance rules prevent the bank from deducting the portion of its interest expense allocable to tax-exempt interest — thus impacting the bank’s yield, often significantly. Some financings will not be eligible to be bank-qualified, and in those cases the bank will want to be sure the absence of bank qualification has been appropriately reflected in the pricing.

Bankers also must be clear as to how the financing will be secured. If the instrument is a general obligation bond, the public entity has pledged its full faith and credit, including its power to levy a tax to service the debt. More often, however, the instrument is a revenue bond – that is, secured by a specified stream of income, e.g., sales tax revenues, sewer or water system revenues, surcharges, etc. One structure often used as a way to avoid election requirements and constitutional debt limits is a lease-purchase arrangement – but such leases are generally subject to annual appropriation or termination. So in these cases it’s important to assess how motivated future governing bodies will be to continue the lease. In addition, SDCL 51A-4-23 requires state-chartered banks to receive the approval of the Division of Banking before financing personal property (i.e., equipment) through the use of a lease-purchase arrangement.

Davenport Evans is recognized bond counsel. When serving in this role, we are typically engaged by the bond issuing entity to provide a legal opinion regarding the validity of the bonds and tax treatment of interest they accrue. Incidental to this role, we perform other functions such as preparation and supervision of bond proceedings. In cases where another firm is serving as bond counsel, we are often engaged by the bank to serve as its counsel (purchaser’s counsel) to help assure the bond it purchases will have the legal and tax attributes the bank expected.

If your institution is considering a public financing transaction and has questions, we invite you to contact us.

Davenport, Evans, Hurwitz & Smith, LLP, located in Sioux Falls, South Dakota, is one of the State’s largest law firms. The firm’s attorneys provide business and litigation counsel to individuals and corporate clients in a variety of practice areas. For more information about Davenport Evans, visit