263

CHAPTER

14
Procedures for
Long-Term Financing
Learning Objectives
After reading this chapter, the student should be able to:
1.	Interact effectively with investment bankers and other financing professionals.
2.	Explain basic procedures and regulations involved in long-term financing.
3.	List and explain the roles of the professionals involved in arranging long-term
financing.
4.	Explain the contents of a financing prospectus to a skeptical board of directors.
1.	
264 • PART 6 Long-Term financing
Key Terms
Best efforts basis	Mandatory
Bond counsel	registration
Bond insurance	Mezzanine financing
Due diligence	Specialist
Feasibility study	Trustee
Full disclosure	Underwrite
Insider trading	Underwriter's spread
External financing (funds obtained from outside the organization) has to come from someone and has to come through some channel. Those someones, individuals and institutions, are called investors, the suppliers of funds pictured in Figure 9-1. The channels through which funds flow from investors to users, the institutions who manage those channels, and the procedures that the users of funds must employ to tap external funds are the subjects of this chapter.
One chapter in a comprehensive textbook cannot make its reader an expert in external financing procedures. After reading this chapter, however, the reader will have a basic understanding of financing procedures and will be prepared to deal with experts in this area.

ACTORS AND FRICTIONS
The image of a market operating without interference, to serve the interests of buyers and sellers, lies at the heart of economic analysis. Economists are not so naive as to believe that market processes are really so ideal, in financial, or any other, markets. Rather, individuals and institutions (accountants, attorneys, auditors, brokers, custodians, dealers, investment bankers, printers, and trustees) stand between buyers and sellers. Not worthless drones or leeches, these actors facilitate exchange.
The payments made to these facilitators ("a cut off the top") are frictions in the market. In physics, theoretical motion is impeded by the presence of friction. Physical friction robs the motion of an object of energy, produces heat (sometimes a lot of heat), and causes the observed speed, acceleration, and distance traveled of the object to be less than it would be in a frictionless world. In financial markets, the frictions caused by the presence of facilitators deprives the parties to any trans-action of some of the returns they would otherwise have received. These institutional frictions can produce a form of heat: legal and regulatory proceedings.
Why then, are all of these "unnecessary" actors involved in the process? In the exchange of securities, users of funds receive money now, in return for which they promise to pay cash flows in the future. The suppliers of funds will not enter into such contracts unless they believe that the user will be able to pay the contractual cash flows and that the contract is enforceable (that is, that in addition to being able to make the contractual payments, the user of funds will, in fact, make the payments). That is why accountants and auditors enter into the process and why

CHAPTER 14 Procedures for Long-Term Financing • 265
legally binding documentation is necessary. Trustees and attorneys are introduced into the process to ensure that contracts are to be enforced.
If the contract implicit in a security's sale is enforceable, the security can be taken to market. Few issuers of securities have the network of contacts to be able to sell stocks or bonds to suppliers of funds (in fact, doing so is called "self-dealing," and is tightly regulated). Rather, specialists in bringing securities to market (brokers, dealers, and investment bankers) offer their services, taking a fee for their trouble. Someone must guarantee the possession of the securities, either in paper form or, more common today, in electronic form. That custodianship is the role of yet other specialists, individual custodians and depository institutions.
Chapter 2 dealt with a recurring theme in health care financial management, agency problems and agency costs. Financial market facilitators are agents of the users of funds who hire them, and agency problems abound when one obtains external financing. One should understand the roles of those facilitators, so that one can manage the agency problems they bring with them and mitigate the agency costs that can decrease the value of the organization.
Anyone who has ever taken out a mortgage, borrowed to finance an automobile or a college education, or leased a computer or television knows that there are strict procedures one must follow to obtain financing. In general, the greater the amount to be borrowed, the more complex are the procedures involved. In general, any issuance of securities, debt, or equity must include full disclosure of all relevant information. The requirement of full disclosure in securities offerings long predates the passage of the federal Truth in Lending Act, which extended such requirements to consumer and mortgage loans.
The process for determining that one has followed the appropriate procedures, obeyed all applicable laws, and made all necessary disclosures is called due diligence. Performing due diligence can protect one from certain types of liability; failure to perform due diligence can expose one to substantial legal liability.

REGULATORS AND REGULATION
Regulators are critical players in securities markets and therefore in external financing. American securities law, as it affects the issuers of securities, is based on the Securities Act of 1933, the Securities Exchange Act of 1934, the common law that has evolved in the courts, and applicable state laws. Securities sold in interstate commerce are subject to regulation under federal law and to registration in each state in which they are offered.
Securities law is a complex, technical field, well beyond the scope of this text. There are a few themes that underlie securities regulation in the United States. Under the separation-of-powers clause of the U.S. Constitution, the federal government has only limited power to oversee the issuance of bonds by state and local governments. Many of the provisions of the 1933 and 1934 acts do not apply at all to the municipal sector, and most provisions do not apply to very small issues of securities.
Mandatory registration is one of those basic principles of federal securities law (federal registration is not required of municipal securities, including hospital rev-

266 • PART 6 Long-Term financing
enue bonds). Non-municipal securities that are to be offered for sale to the public must be registered with the U.S. Securities and Exchange Commission (SEC) and with state securities commissioners (Pointer & Schroeder, 1986). Registration does not imply that the SEC endorses or recommends the securities as investments but does guarantee that certain information is on file and that certain procedures have been followed.
Full disclosure is a duty of every securities issuer and of the agents of those issuers. Under the "general anti-fraud provisions" of the 1933 act, the duty of full disclosure does apply to municipal, as well as to corporate, securities. The duty of full disclosure requires that the issuers of publicly offered securities disclose, in their prospectuses, all materially relevant information about themselves to all who would consider purchasing their securities. Such warts-and-all disclosure can be embarrassing. Some hypothetical examples of facts that must be disclosed (if they be true) include the following: (1) Mr. Smith, the Chief Executive Officer of the Hospital, served a 6-month probated sentence for misappropriating funds from a previous employer; (2) the local health care market is becoming increasingly competitive, threatening the cash flows of the health system; and (3) local public officials have suggested that the hospital should provide more free care to the public, a requirement that could jeopardize the organization's ability to meet its debt obligations.
Once an organization has issued securities to the public, it must continue to disclose all materially relevant information about itself so long as those securities are in the public's hands. In the investor-owned sector, that disclosure takes the form of filing quarterly (form 10-Q) and annual (form 10-K) forms with the SEC. These are now available for all but the very smallest publicly traded firms in electronic form. The SEC's "Electronic Data Gathering and Retrieval" (EDGAR) system is available at no charge at http: / /www.sec.gov/edgar.shtml.
A related, and controversial, principle of securities regulation that affects every issuing organization is that of no insider trading (trading by insiders on the basis of material information gained through a position of fiduciary responsibility). Insiders have access to information prior to its disclosure to the public. Were they to sell (buy) securities the day before an announcement of bad (good) news, they could earn substantial profits at the expense of an uninformed public. To prevent this from happening, insiders (broadly defined to include managers, trustees, attorneys, accountants, investment bankers, and financial printers) may not trade for their own accounts, or for the accounts of others, on the basis of such information. They must hold securities of their organization for at least 6 months after purchase, and they may not breach their fiduciary duties by disclosing inside information to others who can use the information to make gainful trades.
An old adage, well worth remembering, says, "If you don't know the law, know a lawyer." When contemplating issuing securities, confer early and often with legal counsel, your own and that of your investment baker.
MIDDLEMEN
Health care organizations (and other types of nonfinancial organizations) are not equipped to sell their own securities. In fact, even if a health care organi-

CHAPTER 14 Procedures for Long-Term Financing . 267
zation could sell its own securities, it would risk running afoul of the "no self-dealing" restrictions embedded in securities regulation. Several types of specialized organizations have developed to bring new securities to market, and it is to one or more of them that a health care provider should turn to access the capital market. Among these middlemen are investment bankers, brokers, dealers, advisers, and exchanges. Those categories represent separate functions, but several of those functions may be performed by the same organization.
Investment bakers are specialists in bringing securities to market (Bloch, 1986). Investment banking firms (such as Merrill Lynch and Goldman Sachs) are distinct from commercial banking organizations (such as Citibank), separated by the Banking Act of 1937 (also known as the Glass-Steigel Act). Under Glass-Steigel, commercial banks may not underwrite securities except in the municipal sector. This prohibition is breaking down, as some commercial banks have set up independent subsidiaries to engage in securities underwriting.
Typically, an investment banking firm will act as the lead in the financing team (Shields, 1983). In that capacity, the investment banker will act as adviser to the issuer. The advisory service is usually performed for an hourly fee (although some investment banking firms will waive the advisory fee if they also serve as under-writer). Some small investment banking firms, including some specializing in serving the health care sector, limit their services to captaining the team and acting as an adviser.
Often the investment banker will, prior to the sale of the securities, agree to underwrite them. That means that the investment banker will guarantee a net proceed per share (or per bond) to the issuer. The difference between the gross price paid by the investor and the price guaranteed to the issuer is the underwriter's spread. The underwriter's spread, usually 1 or 2 percent of the gross price, is the source of profit for the underwriter. Some issues of securities are not underwritten but are sold on a best efforts basis. Under such an arrangement, the investment banker agrees to make his or her best effort to sell the securities for a fee. Often, especially for large issues of securities, one investment banker is unwilling to underwrite an entire issue alone. In such a case, the lead underwriter establishes a syndicate, with each of several underwriting firms taking a share of the total issue.
When marketing securities to the public, the investment banker is acting as a dealer. Securities dealers purchase securities for and sell securities from their own accounts. One of the most important functions of the investment banker is his or her willingness to "make a market" in the issue after it is sold to the public. That is, to bolster the confidence of investors, and to avoid having to pay a premium based on investors' fear that the issue will be illiquid (fear that they will be unable to resell their holdings), investment bankers announce their intentions to maintain an inventory of securities and to post bid (what they will pay) and ask (what they demand to be paid) prices for the securities for the foreseeable future. That willingness to make a market is unimportant for issues of stocks listed on the organized exchanges, but is very important for bonds and for stocks traded over the counter.
Dealers are distinguished from brokers in that brokers take orders from the public and fill them by acting as agents, making contact with dealers or other, on the

270 • PART 6 Long-Term financing
A FINANCING TALE
To illustrate the roles of the players, including the regulators, in the external financing process, consider a hypothetical not-for-profit organization, Regional Health System (RHS), about to construct an off-site diagnostic center (Thomas Arthur discusses the financing process in detail in Shields, 1983, Chapter 10). After consideration by management, preliminary approval by the trustees, and discussion with a planning consultant, RHS is prepared to proceed with its financing and construction. As a not-for-profit organization, RHS will not issue common stock but will finance the facility with some type of debt security.
RHS would contact an investment banker to serve, first, in the financial adviser capacity. The financial adviser would meet with RHS's senior management, discuss the current and (expected) future state of financial markets, and gain approval for the composition of the financing team. In most states, the financial adviser would also help RHS to obtain approval from the state's Certificate of Need (CON) authority. The application for the CON would contain much of the same information as the prospectus for the bonds to be issued later, so the financial adviser is a key player in its preparation. The financial adviser is compensated for each hour of service.
Because RHS is a not-for-profit health care provider, it can use the municipal bond market to obtain financing. That is, an issue of tax-exempt hospital revenue bonds is probably the best way to finance the new facility. RHS, however, cannot merely decide that its bonds will be municipal bonds; only units of state or local government can issue municipal bonds. RHS's financial adviser must contact the appropriate bond-issuing authority (the identity of that authority varies from state to state) and obtain its cooperation (usually for a fee) in the issuing process. The financial adviser or the issuing unit of government must also bring onto the financing team a bond counsel, a specialist in determining whether or not the issue will, in fact, be tax-exempt. The bond counsel's statement in the bond prospectus has important implications for every tax-paying investor and is a crucial element in the marketing of the bonds.
The financial adviser will engage a consultant to prepare a feasibility study for the bond prospectus. That study, a part of full disclosure, informs potential investors of the type of facility to be built, its probable utilization, and of the projected financial position of RHS after completion of the project and assumption of the associated debt. Other members of the financing team are also brought into the process at this time. These include an auditor to audit the financial statements of RHS, a facilities consultant, and the financial adviser's attorney to ensure that all applicable regulations are followed.
The financial adviser will also take the RHS through the rating process. This will include preparing materials to submit to the agency or agencies chosen to rate the bond and making the presentation to the rater's analysts at their offices in New York or Chicago. This activity can be worth millions of dollars, as poor ratings mean high required yields, and knowledge of what the rater is looking for can mean the difference between a good rating and a bad one.
At this point, the term structure of the bond offering is determined; not all of
bonds in a single issue must mature on the same date (and, when maturities vary,

CHAPTER 14 Procedures for Long-Term Financing • 271
required yields will vary as well). The investment banker now steps out of the adviser role and into the underwriter's role. Some health care organizations prefer to pay a financial adviser who is not to be the underwriter. Increasingly, however, the same firm is both adviser and underwriter.
The financial adviser or the underwriter supervises the preparation of an initial prospectus, providing all of the information a potential investor needs, except the yield and price of the proposed bonds. This is the first step in which the parties must meet the requirement of due diligence, ensuring that all material statements are accurate. The preliminary prospectus (or preliminary statement) is known as a "red herring," because of the red ink that marks it as preliminary. Acting as a dealer, the underwriter circulates the red herring to potential investors during the offering period.
As a municipal issuer, RHS is not subject to federal registration. It is, however, subject to state securities laws, known as "blue sky laws" (because they prevent securities issuers from promising investors "the blue sky"). The underwriter's attorney has the responsibility of seeing that all applicable blue sky requirements are met.
As the offering date draws near, the underwriter, meeting with RHS (and keeping the municipal bond issuing authority informed), sets an interest rate (or rates, if maturities vary) for the bonds. This rate depends on market conditions, the riskiness of the bonds implied by the rating assigned to them, and their maturities. Ideally, the bonds' yield will be set so that the bonds sell at their par (face) value. The underwriter has agreed to turn over a set proportion of the par value to the issuer. The difference between the price of the bonds and the negotiated net proceeds to the issuer is the underwriter's spread and is the financial reward for underwriting.
If the underwriter places a yield higher than investors require on the bonds, the risk that bonds will go unsold, generating an unwanted inventory of bonds and a loss for the underwriter, declines. Underwriters, then, have an incentive to place higher-than-market yields on bonds, forcing unnecessarily high interest payments on the issuer (because yields and prices vary inversely with one another, this tendency of underwriters is also called underpricing; see Bloch, 1986, pp. 127-130). If the underwriter is successful in pursuing that interest, the present value of the additional interest expense borne by the issuer is an agency cost, reducing the value of the issuing organization (see Chapter 2).
With the interest rate set, and investors (who have examined the red herring) at the ready, the financing team is ready for the final session. Closing papers, obligating the issuer to the terms of the trust indenture, must be signed, just as they would in a private mortgage financing. In a final working session, often an "allnighter," the yield(s) are entered into the prospectus and all pro forma (projected) financial statements are recalculated to reflect the effect of that specific interest rate. The data and projections are checked (due diligence again) for accuracy and given to the printer, who will produce the final prospectus (see Figure 14-1).
Were RHS required to do so, its would send its prospectus to the Washington offices of the U.S. Securities and Exchange Commission via courier on the morning after its printing. With a quick stamp-in registration, the bonds would be registered

272 • PART 6 Long-Term financing
and ready, after a required delay, for sale. As RHS is making a municipal offering, federal registration is not required. State registration, however, may be necessary prior to formal offering.
With the prospectus printed and properly registered, closing documents signed, and trustee engaged, the underwriter, acting as dealer, can now call investors and offer the securities. If the underwriter has done its job, the bonds will be sold before the close of business on the first offering day. RHS will receive its funds a few days later, after transfers are completed.

TO INSURE OR NOT TO INSURE: AN NPV PROBLEM
A useful innovation in municipal bond financing has been the emergence of bond insurance. When an issue is insured, the insurer, usually a consortium of insurance companies, such as the Municipal Bond Insurance Association (MBIA), guarantees that the bond holders will receive all of their promised payments. It is the enormous potential liability of the insurer that has caused the formation of consortiums to issue bond insurance.
The issuer of the bond pays the insurer a premium for its services. In return, the issuer's creditworthiness is enhanced. Now, not only is the issuer standing behind the bond issue, but so is the insurer. Clearly, only highly stable and creditworthy insurers carry any weight in the market. Therefore a small number of well-capitalized consortiums dominate this market. Bonds insured by the major players in this market are almost always rated AAA by the major rating firms. The benefit to the issuer is the lower yield associated with the AAA rating. Carpenter (1991) found a substantial reduction in interest payments associated with taking out bond insurance. Note that the bonds whose prospectus is shown in Figure 14—1 were insured by the Municipal Bond Investors Assurance Corporation (see the upper right corner of the cover sheet).
When should one insure one's bonds? The solution is a simple application of net present value analysis. The premium payment to the insurer is an initial cash outflow (CFAT0 <0). Over the life of the bond, usually every 6 months, the issuer enjoys a cash savings (CFATt >0). That savings represents the difference between the interest that the issuer would have to pay, given its credit rating, were the bonds not insured and the interest that the bond issuer has to pay, given that the bonds are insured. The net present value of the insurance purchase is the present value of the interest savings minus the initial insurance premium. If the net present value of the insurance is at least zero, then one enhances the value of the organization by insuring the bonds.

SUMMARY
External financing is a complex process, requiring the services of a large number of experts. One approaches the process only after a lot of preparation. The process of selling securities to the public requires months of effort and tens of thousands of dollars in expense. External financing, however, as discussed in Chapter 15, is often the key to organizational survival and growth.

CHAPTER 14 Procedures for Long-Term Financing • 273
OFFICIAL STATEMENT

$32,308,281.35

Ratings: Moody's: Aaa
Standard & Poor's: AAA Insured by Municipal Bond Investors Assurance Corporation (See "Ratings" herein)

County of Pitt, North Carolina
Pitt County Memorial Hospital Revenue Bonds,
Dated December 1, 1989	Series 1989	Due December 1, as shown below (except Capital Appreciation Bonds, which are dated the date of delivery)
THE BONDS ARE LIMITED OBLIGATIONS OF THE COUNTY OF PITT, NORTH CAROLINA (THE "COUNTY"), PAYABLE SOLELY FROM AND SECURED BY A PLEDGE OF NET REVENUES (AS DEFINED HEREIN) FROM THE OPERATION UNDER LEASE FROM THE COUNTY BY PITT COUNTY MEMORIAL HOSPITAL, INCORPORATED, A NORTH CAROLINA NON-PROFIT CORPORATION (THE "CORPORATION"), OF PITT COUNTY MEMORIAL HOSPITAL LOCATED IN GREENVILLE, NORTH CAROLINA, AND CERTAIN FUNDS AND ACCOUNTS ESTABLISHED UNDER THE BOND ORDER AND THE SERIES RESOLUTION (BOTH AS DEFINED HEREIN) AND HELD BY FIRST-CITIZENS BANK & TRUST COMPANY, RALEIGH, NORTH CAROLINA, AS TRUSTEE. NEITHER THE FAITH AND CREDIT NOR THE TAXING POWER OF THE COUNTY OR THE STATE OF NORTH CAROLINA OR ANY POLITICAL SUBDIVISION THEREOF IS PLEDGED FOR THE PAYMENT OF THE BONDS, NOR WiLL THE BONDS BE OR BE DEEMED TO BE AN OBLIGATION OF THE COUNTY OR THE STATE OF NORTH CAROLINA OR ANY POLITICAL SUBDIVISION THEREOF, OTHER THAN OF THE COUNTY TO THE EXTENT OF THE AFOREMENTIONED SOURCES.
The Bonds are issuable as fully registered bonds. When issued, the Bonds will be registered in the name of Cede & Co., as nominee of The Depository Trust Company ("DTC"), New York, New York. So long as Cede & Co. is the registered owner of the Bonds, principal and interest payments on the Bonds will be made to Cede & Co., which will in turn remit such payments to the DTC Participants (as defined herein) and DTC Indirect Participants (as defined herein) for subsequent disbursement to the beneficial owners of the Bonds. Interest on the Current Interest Bonds (as set forth below) is payable on June 1, 1990 and semiannually thereafter on each December I and June 1. Purchases of Bonds will be made in book-entry form only, and individual purchasers will not receive physical delivery of bond certificates. Interest on the Capital Appreciation Bonds is not payable semiannually but is payable at maturity or upon prior redemption. Individual purchases of Current Interest Bonds will be made in the principal amount of $5,000 or any integral multiple thereof. Individual purchases of Capital Appreciation Bonds will be in the maturity amount of $5,000 or any integral multiple thereof. So long as Cede & Co. is the registered owner of the Bonds, references herein to the holders or registered holders of the Bonds shall mean Cede & Co. and shall not mean the beneficial owners of the Bonds. See "The Bonds — Book-Entry-Only System."
The Bonds are subject to optional and mandatory redemption prior to maturity as more fully described herein.
Payment of the principal of and interest on the Bonds when due will be guaranteed by a municipal bond insurance policy issued simultaneously with the delivery of the Bonds by
Municipal Bond Investors Assurance Corporation.

In the opinion of Bond Counsel, assuming compliance with the provisions of the Internal Revenue Code of 1986, as amended (the "Code"), as
described herein, interest on the Bonds is not includable in the gross income of the recipients thereof for federal income tax purposes.
Interest on the Bonds may be included in the calculation of certain taxes, including the alternative minimum tax on corporations
as described under "Tax Exemption" herein. See "Tax Exemption" herein for a description of certain provisions of the
Code that may affect the tax treatment of interest on the Bonds for certain registered owners of Bonds and for
exemptions from taxation under the laws of the State of North Carolina.
The Bonds are offered subject to prior sale, when, as and if issued by the County and accepted by the Underwriters, subject to the approval of Brown & Wood, New York, New York, Bond Counsel. Certain legal matters will be passed upon for the County by Speight, Watson & Brewer, Greenville, North Carolina, for the Corporation by Poyner & Spruill, Raleigh, North Carolina, and for the Underwriters by Robinson, Bradshaw & Hinson, P.A., Charlotte, North Carolina. It is expected that the Bonds will be available for delivery to DTC in New York, New York on or about January 9, 1990.
The First Boston Corporation
First Union Securities, Inc.	The Robinson-Humphrey Company, Inc.
Interstate/Johnson Lane Corporation	Wachovia Bank and Trust
J. C. Bradford & Co.	Company, N.A.
NCNB National Bank	Wheat, First Securities, Inc.
The date of this Official Statement is December 20. 1989.
Figure 14-1 The cover of the proposal for an issue of hoispital revenue bonds.

274 • PART 6 Long-Term financing
Attorneys, accountants, financial specialists, brokers, bond insurers, regulators, and state bond authorities all have roles to play in the financing process. Health care organizations should rely on advisers whom they trust to help them in financ ing. Health care organizations should also understand what they are getting into, so that their advisers don't burden them with many years of agency costs.
Discussion Questions
1.	Given the procedural and regulatory nightmares involved in selling securities tc the public, why would any organization want to do so?
2.	Give (and explain) a rule for deciding when selling bonds to the public is prefer able to obtaining a bank loan.
3.	Give (and explain) a rule for deciding when to purchase bond insurance.
4.	What are the three major roles of an investment banker? Can they be performer by separate firms for a single issue of securities?
5.	What are some implications of the prohibition of trading on the basis of inside information? Is that prohibition, on balance, worth retaining?
CONTINUING CASE
Roger Jackson was as nervous as he had ever been. Discussions of PCI, Inc.'s potential issue of additional common stock (see the Continuing Case for Chapter 13) had progressed. Now he, Henry Kirk, Janet Fowler, and Jack Hernandez were having lunch at a small restaurant in Dallas. At 1:30, they would meet with a representative of NT Securities, an investment bank specializing in small firms.
Jack Hernandez is a dentist, a long-time tenant of Physicians Clinic, and the second-largest shareholder of PCI, Inc. Jackson and Hernandez, together, control exactly 51 percent of PCI's shares.
"Jack, old buddy, have another glass of wine?" Jackson patronized. Hernandez was calm and thoughtful, deeply distrustful of the deal they might make.
At 1:30, the group from Jamestown met with John Powers of NT Securities in a30th-floor conference room. Powers outlined some issues to consider. The anticipated expenses of preparing a small issue would be $100,000. NT Securities would expect a 2 percent underwriters' spread. NT was prepared to make a market in the stock once it was sold to the public.
"You might even be better off going to a bank. A big bank," Powers offered. "And have you ever thought about the effects of making a pub-