Sorett Co-Authors Law360 Article on Effect of Budgetary Scoring Rules on FBI Headquarters Delay

August 8, 2017

Kutak Rock attorney Steve Sorett co-authored the article "Budgetary Scoring Rules Are To Blame For FBI HQ Setback" for the August 9, 2017 edition of the Law360 online newsletter.

The article, co-authored with Dorothy Robyn, Ph.D., appears below it its entirety:

Last month, the U.S. General Services Administration made front-page news when it canceled its four-and-a-half-year plan to exchange the crumbling J. Edgar Hoover Building for a new, consolidated FBI headquarters in suburban Washington, D.C. Local political officials and members of Congress reacted with anger, and at a hastily scheduled Senate hearing, GSA and FBI officials pledged to come up with an alternative plan within 120 days. The Trump administration should take advantage of this crisis to exempt the FBI headquarters consolidation project from a perverse set of budgetary scorekeeping (scoring) rules, thus allowing the use of private financing to construct the much-needed new facility.

The scoring rules were put in place in the early 1990s when Congress directed the Office of Management and Budget and the Congressional Budget Office to nix federal agencies’ use of long-term lease commitments, paid for through annual appropriations, to purchase capital goods such as buildings and tactical military vehicles. Some agencies had resorted to this practice because, unlike state and local governments, the federal government does not have a capital budget and, therefore, cannot finance capital assets using general obligation or revenue bonds. Although well-intended, the scoring rules have had unintended consequences, forcing agencies to use expensive short-term operating leases to meet long-term space needs and subjecting federal buildings and military bases to chronic deferred maintenance.

Pressing Need for a New FBI Headquarters

The FBI needs a new headquarters. Built in the early 1970s to store mountains of paper files, the Hoover building no longer serves the agency’s needs in a digital age, and the external structure and building systems require major investment. Moreover, Hoover’s location on Pennsylvania Avenue—six blocks from the White House and two blocks from the Trump International Hotel—precludes the perimeter setback required by federal security standards. Finally, Hoover is too small to house the thousands of FBI agents hired after 9/11. Half of headquarters staff is dispersed in some 15 leased locations, which leads to time-consuming travel and inhibits the kind of close collaboration the FBI has sought to encourage in the aftermath of 9/11.

Why GSA Resorted to Barter

In 2013, the GSA rekindled the long-dormant discussion of a new FBI headquarters by announcing that it wanted to swap the current FBI site for a new, larger facility, with the site and developer to be chosen competitively. The GSA invoked its little-used property exchange authority because no other alternative was available. The traditional alternative—a congressional appropriation — was a nonstarter. Under federal budget rules, capital investments must be fully funded in advance. Congress had no interest in finding the $1 billion-plus needed to advance-fund a new FBI headquarters, and OMB thought the project should ideally be done in phases and paid for with existing FBI appropriated funds.

Nor could GSA auction off the FBI’s valuable site to help pay for a new headquarters. When the GSA sells a building, the proceeds go into the Federal Buildings Fund, a working capital fund financed by the rents that federal agencies pay for the space they occupy. Since Congress determines how the fund gets spent to operate and maintain federal buildings, the GSA can’t “earmark” the proceeds from the sale of a particular building for the construction of a replacement building. Moreover, since 2010, appropriators have taken billions of dollars out of the fund to cover non-GSA costs (e.g., U.S. Department of Treasury salaries), forcing the GSA to defer critical maintenance and forego needed new construction.

The GSA’s innovative property exchange plan provided a way to bypass appropriators and ensure that the full value of the Hoover site would go to pay for a new FBI headquarters. The drawback was that the winning developer would not be able to take possession of Hoover until it had completed construction of the new headquarters building, and that lag period would reduce what a developer was willing to pay for the site.

There was another “option” — but it too was a nonstarter. Using the GSA’s “outlease-leaseback” authority, a developer could build a new facility to the FBI’s specifications on federally owned land and lease it back to the FBI. At the end of (say) 30 years, the developer — having recouped its investment — would transfer ownership of the building to the federal government. But that seemingly sensible approach ran afoul of the budget scoring rules that OMB, with strong backing from CBO and the House and Senate Budget Committees, strictly enforces. When GSA lawyers devised an approach to outlease-leaseback that was technically compliant with the scoring rules, the OMB rejected it outright.

The Most Important OMB Document You Never Heard Of

The scoring rules for federal real property transactions are codified in Appendix B of OMB Circular A-11, which sets out criteria for distinguishing a capital lease from an operating lease. The OMB issued Appendix B in 1991 in response to a perfect storm of conditions that led some federal agencies to use long-term leases, paid for through annual appropriations, to buy buildings and other capital assets. Most notable, the U.S. Department of Defense was using leases to acquire noncombat ships and aircraft.

In response to direction from Congress to nix such “lease purchases,” the OMB and CBO looked around and found the accounting rules issued by the Financial Accounting Standards Board that specify when a private company has to disclose leases on its balance sheet to inform investors as to its debt obligations. FASB 13 establishes a six-part test. If any of those tests, or criteria, are not met, then a lease transaction is characterized as a capital lease and must be disclosed. If all six tests are met, then the transaction is characterized as an operating lease and no disclosure is required.

The OMB adopted the FASB 13 tests as the basis for determining whether a lease associated with a federal transaction was an operating or a capital lease. The OMB also adopted FASB’s all-or-nothing approach: if any single test is not met, the transaction is considered a capital lease. But whereas disclosure of a capital lease has limited financial implications for a private company, if a federal agency’s transaction gets scored as a capital lease, the budgetary implications are so severe as to preclude the transaction. Specifically, the agency must receive an appropriation for the full value of the lease up front, even though the disbursements will occur over many years — equivalent to requiring a homebuyer to have 30 years of payments in the bank when he signs the mortgage. By contrast, an operating lease is scored on an annual basis, meaning the agency can budget for it year by year.[1]

At the time that OMB applied FASB 13 in Circular A-11, the intent was to revise and perfect the scoring rules to reflect the different nature of budget decision making versus disclosures on company balance sheets. However, this fundamental revision never occurred, and in fact, the FASB is now in the final stages of abandoning the six-part test, beginning on Dec. 15, 2018, for publicly traded companies.

Unintended Consequences

The OMB and CBO defend the scoring rules on two grounds. One is budget transparency: like an installment plan, lease-purchases and other privately financed ventures “hide” the government’s real long-term cost commitment, leading to suboptimal decision-making in the annual budget process. The other rationale for the scoring rules is cost: Budget agencies argue that it is less expensive for the federal government to buy a capital asset such as a building directly than to finance it privately, because of the lower rate at which the U.S. Treasury can borrow.

The cost argument is tricky because the federal government’s interest-rate advantage is often swamped by other cost factors, such as the longer completion time for federally funded projects compared to those that are privately financed. Cost comparisons notwithstanding, the premise underlying Circular A-11 — that federal agencies would be able to absorb the funding spikes that direct purchases of new buildings and building renovations entail — has proved false over a 26-year period of unrelenting budget pressure. The result has been a textbook example of unintended consequences: lacking the resources to meet genuine facility requirements, federal agencies have resorted to practices more costly — and no more transparent — than the ones Circular A-11 was designed to combat. The GSA has been forced to use expensive short-term operating leases to meet what amount to long-term space needs, and the building infrastructure at military bases is a study in the high cost of deferred maintenance.

One illustration of the perversity of Circular A-11 scoring rules is the new (2006) U.S. Department of Transportation headquarters, which the GSA sited on the Anacostia River in Southeast Washington, D.C., in part to spur development there. The GSA leases the 1.35 million square foot building, which was purpose-built for the DOT, for $45 million a year under a 15-year operating lease — a 20-year lease would have been scored as a capital lease using one of the Circular A-11 criteria. Another Circular A-11 criterion prohibited the GSA from entering into a lease that would have given the government ownership of the building at the end of, say, 25 years or that would have included a major discount on the building’s end-of-lease market price. Commercial lessors often agree to such a “bargain transfer” because at that point, the building has been fully depreciated on their balance sheet. So, in 2021, having spent $675 million to lease a building that cost only $400 million to build, the GSA will have to sign another 15-year lease. The federal government will have no equity in a property whose value has soared because of the surrounding development it helped spur — and no end in sight to costly rent payments.

Exempt the FBI Headquarters Project from Circular A-11

The GSA canceled the exchange process on the grounds that it lacked sufficient appropriated funds to cover the difference between developers’ bids for the Hoover site and the (now inflated) cost of a new FBI headquarters. That rationale is not entirely persuasive: Privately, the GSA never expected the proceeds from the sale of Hoover to fully offset the cost of the new headquarters. Nevertheless, the plan to swap Hoover for (part of) a new FBI headquarters appears to be dead. (Lest this be seen as an indictment of federal property exchange, note that the GSA recently used its exchange authority to reach a $750 million deal with the Massachusetts Institute of Technology. MIT agreed to build a new research facility for the DOT’s Volpe Center in Cambridge, Massachusetts, in exchange for the right to develop the remaining portion of Volpe’s 14-acre campus — prime property in Cambridge’s high-growth Kendall Square that Volpe uses for surface parking.)

While regrettable, this decision need not take the process of getting a new headquarters back to square one, as many commentators and critics have assumed. But to salvage the effort, members of Congress and local political officials need to redirect their anger from the GSA to the budget scoring rules. If the Trump administration were to exempt the FBI headquarters consolidation project from Circular A-11, the GSA could use its outlease-leaseback authority to take advantage of private financing. Ideally, the GSA would be able to preserve key results of its aborted procurement process, particularly the multiyear environmental reviews of candidate sites that are the bottleneck in any such process.

The administration does not need congressional approval to proceed, since the GSA already has the necessary legislative authority. However, congressional buy-in is critical, since the CBO and the Budget Committees work closely with the OMB to enforce the scoring rules.

What is needed is a memorandum from the director of the OMB stating that the FBI project will be scored on an annual basis, meaning that the budgetary cost can be recorded over the term of the project and not entirely in the first year. Precedent for this exists: In 1997, the OMB granted the DOD a waiver from Circular A-11, allowing the armed services to partner with the private sector to address the lack of adequate housing for military families.

Looking Beyond the FBI Headquarters Consolidation Project

Looking beyond the FBI project, this is an opportune time for the administration to undertake a comprehensive review of OMB Circular A-11, Appendix B. Much has happened since 1991 when the scoring rules came into effect. With the FASB’s abandonment of its six-part test, the legal and accounting underpinning for the OMB scoring rules is being eroded. And experience has shown that reliance on appropriated funds alone imposes its own costs. Third-party financing, which the rules preclude, is one if not the only way to address key federal real property needs, including reducing excess capacity in the federal inventory, moving agencies out of expensive leased space into federal buildings where appropriate, cutting long-term maintenance costs, and improving agencies’ ability to perform their missions.

The administration can take modest steps immediately through changes to some of the more onerous scoring rules as well as by setting in place a waiver process for deserving projects. Most importantly, the administration needs to communicate clearly to the third-party financing community what the rules are and when to expect timely decisions.

Many government managers are hopeful that President Donald Trump, who knows buildings and understands the cost of deferred maintenance better than any of his predecessors, will want to make this a policy priority. Making the new FBI headquarters a pilot project in more flexible financing is a valuable action in its own right, and it would be a smart way to start a much-needed re-examination of our approach to government buildings.

[1] For more detail on the scoring rules, see Dorothy Robyn, “Reforming Federal Property Procurement: The Case for Sensible Scoring,” Brookings Institution, April 24, 2014. See also Steve Sorett, "Federal Infrastructure and the Funding Dilemma."