Executive Summary 5.5. Direct the City Manager to establish a policy requiring the Sclaa Board of Directors to

Recommendations 1

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  Inter-fund Loans and Use of Restricted Funds  Despite repeated recommendations from independent auditors and members of City management as early as February of 2009, the City of Victorville did not adopt a formal Inter-fund Loan policy until May 3, 2011. The adopted policy contains significant weaknesses, including the lack of guidelines and required analysis to determine: (1) the borrowing and lending funds’ solvency; (2) timeframes for analysis and approval prior to June 30 of each fiscal year to prevent backdating of loans; and, (3) financial planning and monitoring of the repayment of the loans. Without such guidelines, approval of inter-fund loans could weaken the financial condition of lending funds, result in permanent contributions from the lending fund to the borrowing funds, and complicate or misrepresent the financial condition of all funds involved.  As of June 30, 2011, the City had at least $69.7 million in outstanding inter-fund loans. A review of these loans demonstrates that a majority of the borrowing funds have not made any repayment toward the loans, and internal controls are not formalized to ensure repayment. Additionally, $38.1 million, or 54.7 percent of the borrowed funds were provided to the Southern California Logistics Airport Authority (SCLAA) or the Victorville Municipal Utility Services (VMUS), two entities with significant debt obligations, structural cash flow difficulties, and revenue concerns. The ability of these two entities to repay the inter-fund loans is highly questionable.  The California Constitution imposes restrictions on the use of fees imposed for water delivery, sewer services, and garbage collection. Specifically, revenue from property related fees or charges should not exceed the amount required to provide such services, or be used for any purpose other than what the fee or charge is intended. The Constitution does not prohibit investments or short-term loans from restricted funds. However, given that the financial condition of VMUS makes it likely that the $22.1 million in outstanding inter-fund loans from the Victorville Water District (VWD) could go unpaid, making it a permanent contribution to VMUS operations, then the City is at risk of violating the Constitution. Notably, the City Manager asserts that the City will use approximately $45 million of $52 million in judgment proceeds from a suit against a prior engineering contractor to repay the loans.  In September 2008, the Local Agency Formation Commission (LAFCO) adopted a resolution to dissolve the Sanitary District and designate the City of Victorville as the Successor Agency. Subsequent to the dissolution, the City transferred $15 million in property tax revenue from the Sanitary District to the General Fund. To date, the City has not provided sufficient documentation for the reason why only $15.0 million of the $17.8 million in property tax revenue was transferred to the General Fund. More importantly, however, the transfer of such funds violates the conditions set forth in the LAFCO resolution, which states that all Sanitary District funds shall be maintained in a separate enterprise account. Additionally, use of the property tax revenue for purposes other than for Sanitary District services would also be in direct violation of the California Constitution. Harvey M. Rose Associates, LLC 2-1 Section 2: Inter-fund Loans and Use of Restricted Funds Inter-fund Loan Policy Adopted, but Contains Weaknesses According to City management, the City has been engaging in inter-fund loans when various funds draw a negative cash balance, or expenditures exceed cash on hand, for several years. Despite recommendations from several parties to formalize these inter-fund loans through loan documents, the City has inconsistently formalized loan documents for inter-fund loans. Additionally, it is not clear what standards and criteria the City has used to guide its inter-fund loans until a policy was adopted by the City Council on May 3, 2011. Improvements should be made to the Inter-fund Loan Policy to ensure that inter-fund loans do not: (a) significantly weaken the financial condition of a lending fund and its ability to pay obligations; (b) become a permanent contribution to the borrowing fund; or, (c) misrepresent the financial condition of all funds involved. City was Slow to Adopt Inter-fund Loan Policy In February 2009, Caporicci and Larson, the independent auditors for the 2007 financial statements, recommended that formal agreements should be obtained between funds providing and borrowing cash. In May and June of 2009, the former Director of Finance submitted a draft and a revised draft of an Inter-fund Loan Policy to City management. The former Director of Finance recommended approval by the City Council prior to June 30, 2009, in anticipation of inter-fund loans that were proposed to be a part of Fiscal Year (FY) 2008-09. Current City management reports that they do not know why the Inter-fund Loan Policy was never adopted in 2009 under the former City Manager, though several members of the existing City management were recipients of the draft Inter-fund Loan Policy. In its audit of the 2008 financial statements, Mayer Hoffman McCann P.C. also recommended that the City formally approve and document inter-fund loans that were approved as long-term advances between funds. As a result, the City approved formal loan documentation for two inter- fund loans on September 15, 2009: loans between (1) the Victorville Water District and VMUS, and (2) the Victorville Redevelopment Agency and SCLAA, which are discussed later in this Section of the report. Subsequent to the auditors’ recommendations, several inter-fund loans have been formalized, while others have not. This is also further discussed later in this Section. Since the draft Inter-fund Loan Policy submitted to City management in 2009 was never adopted, it is not clear what criteria and guidelines were used to identify lending agencies and repayment terms of the loans approved prior to May 3, 2011, when the City Council adopted its current Inter-fund Loan Policy. Vague Inter-fund Loan Policy The Inter-fund Policy states that loan documents in the form of a Promissory Note must be prepared by the City Attorney and approved by the City Council when the following conditions are met: Harvey M. Rose Associates, LLC 2-2 Section 2: Inter-fund Loans and Use of Restricted Funds  A fund has insufficient cash in the bank to pay for incurred expenditures, or has a cash shortfall;  Temporary borrowing of funds from another fund is needed to meet expenditure requirements prior to the close of the fiscal year; and,  The loan or advance of funds cannot be repaid in the current fiscal year, but will be repaid within five years. Financial Analysis Prior to Loan Documentation The existing policy only vaguely states that a periodic analysis is done to identify a fund that has significant expenditures that cause the borrowing need and that a proposed lending fund is identified. According to City management, the periodic analysis is currently a quarterly report on cash balances prepared by the Finance Department and presented to the City Council, though the goal is to make the reports monthly. However, the Inter-fund Loan Policy does not provide guidelines nor require an analysis of the borrowing and lending funds’ solvency, or ability to pay obligations. For example, if the lending fund is in a poor financial condition, then the lending fund may not have sufficient funds to pay for salaries, operations, or debt service after providing funds to the borrowing fund. Similarly, if the borrowing fund is in a poor financial condition and is unable to repay the debt within the terms set for the inter-fund loan, the inter-fund loan could become a permanent contribution to the borrowing fund. In certain circumstances, as discussed in more detail later in this section, this would be a violation of the California Constitution. The Inter-fund Loan Policy should be revised to include an analysis of the financial condition of each fund involved in the inter-fund loan. To the extent possible, only funds in a relatively stable financial condition should be included in the inter-fund loan. Key factors to review for determining each fund’s ability to continue to pay obligations such as the cost of ongoing operations; principal and interest payments for long-term debt, whether it’s commercial debt or inter-fund loans; and other legal obligations specified in agreements or contracts with third parties, include:  Annual revenues and expenditures: do revenues match or exceed annual expenditures, or is the fund consistently spending more money than it receives, resulting in the use of reserve funds or reliance of inter-fund loans to address cash shortfalls;  Annual assets and liabilities: does the fund have so much debt that its total liabilities annually exceed its assets, indicating that the fund may have obligations with a higher priority of repayment than an inter-fund loan, such as bonded indebtedness; and,  Potential sources of revenue: will the fund see a predictable increase in revenue, such as an increase in property, sales and franchise taxes with a rebounding economy; additional rent revenue from existing and/or new airport tenants; increases in user fees and charges; or significant proceeds from the sale of property or other assets? Harvey M. Rose Associates, LLC 2-3 Section 2: Inter-fund Loans and Use of Restricted Funds Clear and Reasonable Timeframe for Analysis and Approval According to the staff report to the City Council when the Inter-fund Loan Policy was approved, a promissory note will be submitted for approval to the City Council prior to the close of the books for any given fiscal year. Therefore, the promissory note could be submitted for approval two to three months after the end of the fiscal year because revenue collection still occurs after June 30, the last day of the previous fiscal year. In other words, the existing Inter-fund Policy permits the backdating of inter-fund loans. The backdating of inter-fund loans, generally, is not fiscally prudent and should be avoided except in unique circumstances. Approving an inter-fund loan months after determining a need to enter into one to close cash shortfalls identified on June 30 of the fiscal year, and then backdating that loan, is like taking a car home from a dealership, then waiting to receive additional commission or a raise in the next couple of months before returning to get approval for a loan to pay for the car. With adequate tools such as financial reports on cash balances, expected revenue and projected expenditures, the City should be able to determine an appropriate amount for a loan and approve the loan prior to June 30 of the fiscal year. Should revenues collected after June 30 be more than expected, then the borrowing fund could repay the inter-fund loan more quickly. Financial Planning and Monitoring of Repayment Although the Inter-fund Loan Policy makes some reference to repayment terms, City management has reported that it currently does not have any internal controls to ensure that the borrowing fund meets the repayment terms specified in the loan documents. The policy only states that the loan documents should include: (a) the maturity date on which all principal together with all accrued and unpaid interest will be due and payable; (b) an applicable interest rate; and, (c) that the borrowing fund has a right to make full prepayment at any time without penalty. However, according to the Government Finance Officers Association (GFOA), prudent measures should include documentation of a financial plan reflecting a repayment schedule. To prevent inter-fund loans from becoming permanent contributions or transfers to the borrowing fund, the City should include financial plans in its loan documentation for approval by the City Council. The financial plans could include specific amounts in the repayment schedule, starting with low payment amounts and then increasing throughout the term of the inter-fund loan. Alternatively, financial plans could specify that a percentage of surplus revenue at the end of every year in the term of the loan should be made toward the payment of the loan, with the total balance due by the maturity date. The financial plan could also document any anticipated increases in revenue, such as the completion of revenue generating projects, or the sale of assets. At a minimum, City management should be monitoring a borrowing fund’s ability to make payments throughout the term of the loan. City management reports that during the budget process, the Finance Department conducts an informal analysis of surplus funds that could be used to pay off some of the inter-fund loan. This process should be formalized and tied to any financial plans included in loan documentation. Harvey M. Rose Associates, LLC 2-4 Section 2: Inter-fund Loans and Use of Restricted Funds Outstanding Inter-fund Loans Exceed $69 Million As shown in Table 2.1 below, the City had at least $69,666,316 in outstanding inter-fund loans as of June 30, 2011, including original loan amounts and accrued interest. The inter-fund loans included in Table 2.1 are those transactions included in the City’s FY 2010-11 financial statements as “Advances to/other funds,” which should have had loan documentation executed by June 30, 2011. Note that all of the loans below were executed on or after June 30, 2009 because, according to City management, this is when the City began to formalize inter-fund loans from one entity to another in response to independent auditors’ feedback. Harvey M. Rose Associates, LLC 2-5 Section 2: Inter-fund Loans and Use of Restricted Funds Table 2.1 Inter-fund Loans for the City of Victorville as of June 30, 2011 Borrowing Lending Original Date of Balance as Fund1 Fund Amount Loan of 6/30/11 Purpose RDA - Project Area Bear Redevelopment activities on SCLAA Valley $10,000,000 9/15/2009 $10,114,922 SCLA,2 such as the fuel farm RDA - Redevelopment activities on Low and SCLA, prior years' capital Moderate improvements, and project SCLAA Housing 1,700,000 10/20/2009 1,715,210 expenses General Inter-fund borrowing due to SCLAA Fund 2,314,8513 6/30/2011 2,314,851 negative cash balances Inter-fund borrowing due to SCLAA VMUS 1,230,671 6/30/2011 1,230,671 negative cash balances Wastewater Enterprise Inter-fund borrowing due to SCLAA Fund 589,949 6/30/2011 589,949 negative cash balances Subtotal for SCLAA 15,835,471 15,965,603 Capital improvements, general administrative and operating expenditures from VMUS VWD 20,000,000 6/30/2009 20,229,844 prior years Capital improvements, general administrative and operating expenditures from VMUS VWD 2,700,000 11/09/2009 1,878,724 prior years Subtotal for VMUS 22,700,000 22,108,568 RDA - Low Land acquisitions associated and Moderate with the Old Town Project Housing SCLAA 6,906,148 7/21/2009 6,978,386 Area Wastewater Treatment VWD SCLAA 20,000,000 7/23/2009 22,711,781 Facility on SCLA General Fund /Development Land acquisitions associated Impact Fund SCLAA 1,895,090 9/21/2010 1,901,978 with the public library Total $67,336,709 $69,666,316 Source: City of Victorville Financial Statements 1 Borrowing/lending funds include: Southern California Logistics Airport Authority (SCLAA), Victorville Redevelopment Agency (RDA), Municipal Utility Services (VMUS), and Victorville Water District (VWD). Southern California Logistics Airport (SCLA) is the physical airport property. The City Manager had stated that these funds were provided to SCLAA as “a short term advance” and have since been repaid. The City Manager has further stated that this amount “may exist again at the end of this fiscal year.” Harvey M. Rose Associates, LLC 2-6 Section 2: Inter-fund Loans and Use of Restricted Funds Table 2.1 does not include inter-fund loans made between the Low and Moderate Income Housing Fund and other Victorville Redevelopment Agency (RDA) funds. The balance of inter- fund loans within the RDA was an additional $9,813,531 as of June 30, 2011. Terms and Repayment With a few exceptions, the inter-fund loans listed in Table 2.1 have a term of five years and have an interest rate equivalent to the Local Agency Investment Fund (LAIF) rate of return. As of December 2011, the LAIF rate of return was 0.38 percent. These terms and interest rates appear to be consistent with the City’s inter-fund loan policy, which requires repayment within five years and at an appropriate interest rate. Unlike the other inter-fund loans, the inter-fund loan between the Victorville Water District (VWD) and SCLAA for $20,000,000 was originally for a two year term with a seven percent interest rate. According to City management, the loan was originally set for two years because the City anticipated funds from the EB-5 program, which would have secured foreign investor money for planned development projects. However, after the EB-5 program was terminated, the City requested an extension of the inter-fund loan between VWD and SCLAA to five years. Additionally, the interest rate for this loan is seven percent, because the source of funds for the loan is unencumbered funds from SCLAA Housing bonds, which, according to the indenture, must be set at a market rate interest rate. Based on internal work papers provided by City management, most of the borrowing funds have yet to make a single payment toward the repayment of the inter-fund loans. However, there was a payment made from VMUS to the VWD and the outstanding balance is now $1,878,724, as of June 30, 2011. It is not clear why payment installments were not made on both outstanding inter- fund loans between VMUS and VWD. As previously mentioned, City management does not have any formal internal controls to ensure that the inter-fund loans are repaid within five years. Financial Condition of Borrowing and Lending Funds As previously discussed, an adequate inter-fund loan policy should include an analysis of the financial condition of the borrowing and lending funds. A review of the annual revenues, expenditures, assets, liabilities, and potential sources of revenue for the borrowing funds listed in Table 2.1 suggest that SCLAA, VMUS, and the General Fund may have insufficient financial capacity to repay the inter-fund loans within the terms of the loans. Additionally, SCLAA and VMUS have significant bonded indebtedness, which have a higher priority of repayment based on conditions established in the bond indentures, including penalties if the borrowing entities miss scheduled payments or default on other debt obligations. The financial condition of SCLAA, VMUS, and the General Fund are further discussed in Section 1 of this report. Three of the inter-fund loans listed above, between SCLAA and other funds, do not have any formal loan documentation. According to City management, appropriate lending funds still need to be identified prior to requesting approval from City Council, because the current funds listed in the financial statements—the General Fund, VMUS, and Wastewater Enterprise Fund – are in a weak financial state. Harvey M. Rose Associates, LLC 2-7 Section 2: Inter-fund Loans and Use of Restricted Funds Backdating of Loans The inter-fund loans made to SCLAA from VMUS and the Wastewater Enterprise Fund4 in 2011, which have still not received City Council approval as of the date of this report, are examples of inter-fund loans that will be backdated, or approved, after they first appear in the City’s accounting records or audited financial statements. As previously noted, the Inter-fund Loan Policy allows City management to submit loan documentation two to three months after the end of the fiscal year because revenue collection still occurs past June 30, otherwise known as backdating loans. However, the suggested timeframe for backdating loans has significantly passed. As discussed in Section 1 of this report, the City should identify lending funds and formalize loan documentation as soon as possible. As shown in Table 2.2, there have been other instances where inter-fund loans are first mentioned in the financial statements, but are not presented to City Council for consideration until months after the date of the loan. Table 2.2 Backdated Inter-fund Loans for the City of Victorville Date First Appeared, or Date on Referenced in Promissory Note, Borrowing Lending Original Financial or City Council Fund Fund Amount Statement Approval SCLAA RDA $10,000,000 6/30/2009 9/15/2009 VMUS VWD 20,000,000 6/30/2009 9/15/2009 VMUS VWD 2,700,000 4/13/2009 11/9/2009 Source: City of Victorville Financial Statements In addition, the City has noted one lending fund and amount in its financial statements, but then approved a different lending fund or amount in backdated loans. For instance, the FY 2009-10 financial statement notes that $5,073,220 was loaned from the General Fund to the Golf Course fund. However, when documentation of the inter-fund loan was requested, City management provided documentation of the approval of $6,335,780 in total funds loaned to the Golf Course fund from the Solid Waste Management Fund ($2,300,000), Source Reduction and Recycling Fund ($2,935,780), and Landfill Mitigation Fund and ($1,100,000). According to City management, the amount included in the loan document for the inter-fund loans to the Golf Course fund will not reconcile with the figures in the financial statement because the advances were “simply used to document positive balance coverage of negative balances.” In other words, the amount documented in the audited financial statements represents the amount needed at the close of the fiscal year. However, as time passes between June 30 of a 4 As previously mentioned, the City Manager has stated that the $2.3 million advance from the General Fund has been repaid, but may appear again at the end of the current fiscal year. Harvey M. Rose Associates, LLC 2-8