Report 2011-131 Summary - June 2012

City of Vernon: Although Reform Is Ongoing, Past Poor Decision Making Threatens Its Financial Stability

HIGHLIGHTS

Our review of the City of Vernon (city) highlighted the following:

RESULTS IN BRIEF

The City of Vernon (city) is an industrial city located southeast of the downtown district of the City of Los Angeles. The city operates under a city charter initially adopted in 1988 by the city's electorate. Covering approximately 5 square miles, the city is home to more than 1,800 businesses providing 55,000 jobs within the city boundary, though its population consists of only 112 residents. Under its charter, the city is governed by a five-member city council, elected to five-year staggered terms. The city's 275 employees are overseen by a city administrator, and the city provides various public services, including fire, police, health, community services, electricity, water, and gas. For fiscal year 2011-12, the city had general fund budgeted expenditures of $61.6 million, and total city expenditures were budgeted at $325.7 million.

In response to past scandals involving three former city executives, allegations of improper elections, and excessive salaries, in December 2010, the Legislature introduced Assembly Bill 46 to disincorporate cities with populations of fewer than 150 people—which would have applied only to the city. The legislation was not enacted, and as we discuss throughout this report, as part of its efforts to avoid disincorporation, the city adopted a governance reform package with the goal of promoting transparency and accountability, including various reforms involving housing, contracting, and internal policies and procedures.

The city is making progress in enacting the reform measures but has not yet developed the policies and procedures necessary to implement some of them, and for others, it will take years to achieve the full benefits of the intended reforms. For example, although the city amended its charter to address the voter-approved change to remove the requirement that city employees serve at the will of the city council, the city has not yet developed an alternative employment structure, such as a civil service system, which would promote hiring on the basis of qualifications and fitness. In addition, although the city has made some progress in implementing a number of reform measures related to a state senator's direction to double its electorate, full reform of the city's housing practices will take years to achieve.

The city also has not properly managed its executive positions. For example, it has failed to establish minimum qualifications for several key leaders, including the city administrator, city treasurer, and city clerk. Without minimum qualifications the city cannot ensure that it hires individuals with the proper qualifications and experience to succeed in their roles. The city has been without a director of human resources since July 2009, but it is in the process of hiring an individual who will be responsible for addressing these personnel concerns. Further, the salary survey the city completed in May 2011 did not consider some important factors when it compared its executive salaries to those in other cities. For example, the city did not consider the organizational size and structure of the other cities, the scope of responsibilities and duties of the positions being compared, or the qualifications associated with those positions. As a result, the city may not have chosen positions in the most comparable cities for its salary survey. Further, the city may have provided legally questionable retirement benefits to certain current and past executives, entitling them to more generous retirement benefits.

The city's inadequate contracting policies and weak internal controls have resulted in poor practices for developing, awarding, monitoring, and making payments on service and consultant contracts. Our analysis of selected contracts active between 2007 and 2011 revealed problems with 21 of the 25 contracts we reviewed. Specifically, we noted problems such as contracts awarded without a competitive bidding process, contracts that had no ending dates for the period of service, a lack of expenditure limits, poorly defined scopes of work or deliverables, and inadequate monitoring of payments to contractors. Because of these poor contracting practices, the city cannot ensure that it receives the best value for the money spent on services.

Further, we noted that the city did not always ensure compliance with aspects of its conflict-of-interest code, which requires it to determine and document in writing whether each consultant it hires performs duties that require disclosure of economic interests. Such duties include ones that involve making, participating in, or influencing governmental decisions. The city uses a number of consultants to provide it with advice on significant financial transactions, such as bond issues, city financing, and the purchase of assets, and we believe the city should have considered whether these consultants needed to file statements of disclosure. Without financial disclosures by consultants that perform duties requiring disclosure, the public may be unaware if consultants are acting in their own interests rather than in the best interest of the city.

The city's current revenue structure for its general fund does not provide sufficient revenue to pay for the services that the general fund provides. In fiscal year 2010-11 the general fund had revenues of only $27.9 million to cover expenditures of $55.9 million, leaving a structural deficit of $28 million. For more than 20 years the city has operated its general fund at a deficit, and during the five fiscal years encompassing 2006-07 through 2010-11 significant increases in general government and public safety expenditures, its two largest cost categories, caused this deficit to increase to the highest levels of the 20-year period. Over these five fiscal years, the city's public safety expenditures increased by nearly 29 percent for salaries and benefits, even though police staffing decreased over this same period.

The city has funded past general fund deficits through reserves, interfund transfers and loans, and one-time revenues such as the sale of property. Although such practices may be common among California cities, the city's continued and increasing reliance on other funds to cover its general fund deficits is now problematic because the funds available from these sources have decreased. As a result, to address a projected general fund budget shortfall for fiscal year 2012-13, the city has proposed a parcel tax on businesses to generate new revenues.

The city's budget process lacks transparency that would improve the public's understanding of the city's financial challenges. The city displays its budget to the public in an aggregate fashion, making it difficult to clearly see the general fund deficit. The city's budget document also does not discuss the city's efforts to address its challenges, such as the general fund deficit. Unlike other cities, the city lacks documented financial policies for use in developing and managing its budget. Implementing recommended best practices would be a positive step toward formulating the city's financial policies.

The city has not developed a policy to guide its decisions to issue debt and ensure that they are consistent with the city's goals and principles of sound financial management. The city considers the bond covenants in the bond official statements a sufficient debt policy. Although these documents provide some restrictions for debt, they are mainly designed to protect bondholders and not the city. Once the city redeems the bonds, any restrictions and other guiding controls contained in the bond covenants are no longer in effect. Additionally, for significant debt decisions we reviewed between 2004 and 2012, the city council's agenda documents show it was provided with little to no information that summarized and explained the fiscal impact and potential risks associated with those decisions.

Between 2004 and 2012, the city issued more than $1.3 billion in bonds, primarily from its Light & Power Department (power department). As of March 2012 there were $571 million in bonds still outstanding. In addition to these bonds, the city has two outstanding interest rate swaps1 for which it is obligated to make fixed rate interest payments in return for variable rate interest payments. The city's total estimated debt service for the bonds and swaps will be more than $60 million annually for the next 10 years. Of the outstanding debt, $504 million is for three separate bond issues to fund activities of the power department. The largest of these issues, of which $388 million is still outstanding, is debt owed for the city's fixed-rate purchase of a 15-year supply of natural gas that it can no longer use to fuel a power plant the city sold less than two years after the gas purchase.

To satisfy the debt service on these three outstanding obligations, the city pledged revenues from power department operations, primarily from the sale of electricity to the city's businesses. The power department has struggled to manage this debt burden while maintaining the competitive electric rates necessary to attract new ratepayers into the city. At the city's current electric rates, the power department is forecasting a $24 million deficit in the light and power fund beginning in fiscal year 2013-14, which pays for the cost of electricity in addition to paying the debt service on the bonds, creating a need for electric rate increases.

The city also lacks a clear energy strategy. Our finance and energy expert's review of various energy-related transactions over the past several years indicated a lack of documented analyses to support the city's decisions to enter into these transactions, which raise concerns about the city's vision going forward. For example, the city sold its electrical power plant shortly after construction was complete and less than two years after it purchased a 15-year prepaid supply of natural gas for the power plant. Because the city issued tax-exempt bonds to purchase the supply of gas, selling the power plant created the need for the city to also sell this prepaid natural gas supply or risk losing the bonds' tax-exempt status; as a result, it had to sell the gas at a significant discount. Additionally, our finance and energy expert concluded that the city's decision to purchase a prepaid supply of natural gas, with 75 percent of the purchase at a fixed price, was unreasonable.

The city has used interest rate swaps to hedge risks associated with issuing bonds, which is a practice consistent with other municipalities. However, the city lacked an effective process for appropriately evaluating the risks and benefits of swaps before entering into them. Further, contrary to best practices, some of the swaps that the city entered into were for speculative purposes, in which the city essentially took a bet that interest rates would move in its favor. Other swaps exposed the city to financial risks that proved to be costly. The city has terminated all but two of the swaps it entered into since 2003 at a cost of $33.4 million, but lacks a clear process for deciding when to terminate these two remaining swaps. As of February 2012 termination would have cost the city $47 million.

RECOMMENDATIONS

To increase accountability and transparency in its governance, the city should ensure that specific reforms are appropriately implemented.

To ensure that it develops complete and appropriate personnel policies and procedures, the city should continue its efforts to hire an experienced human resources director and have this individual address the weaknesses we identified in the city's management of executive positions.

To ensure accurate reporting and payment of retirement benefits, the city should work with the California Public Employees' Retirement System to resolve the reported findings and observation noted in its April 2012 report within a reasonable period of time.

To better control contract expenditures and ensure that it receives the best value for the services it purchases, the city should develop a comprehensive contracting policy to address the contracting weaknesses we observed and apply this policy to current and future contracts.

To comply with its conflict-of-interest policy, the city should ensure that all city executives file statements of economic interests as required and should review existing and future consultant agreements to determine which consultants should file statements of economic interest.

To address the structural deficit in its general fund, the city should seek long-term solutions to balance the general fund's expenditures and revenues. It should also ensure that city budgets clearly present the general fund structural deficit, and provide narrative explanations to help the city council and the public understand the city's priorities and challenges.

To better guide its budget preparation and improve transparency, the city should develop financial policies and ensure that its budgets include the information required in the Vernon City Code and follow best practices, and also establish a centralized process to regularly monitor and report on the status of the budget.

The city should establish a comprehensive debt policy to better guide its decisions to issue debt that is consistent with the city's goals and principles of sound financial management. To ensure that the city council and public are well informed regarding proposed debt decisions, the city should provide summary information that clearly explains the costs, risks, and benefits related to the proposed decisions in its agenda packets and should provide these in advance on its Web site.

To ensure that it can demonstrate sufficient analyses and provide justifications for its decisions on significant energy-related transactions, the city should develop an integrated energy strategy that examines all elements of its energy needs, sources, and objectives.

The city should develop a strategy to terminate the two outstanding swaps based on the cost and future risk to the city. It should also develop a policy to ensure that it appropriately analyzes and documents the risks and benefits of any future swap transactions.

AGENCY COMMENTS

Although Latham & Watkins LLP, on behalf of the city, disagreed with our findings and conclusions, it acknowledges agreement with many of our recommendations and notes that the city is taking steps to implement them.

1 An interest rate swap is a contractual agreement between two parties, known as counterparties, who agree to exchange interest rate-based cash flows over a certain period.