Old rules, new problems

As the US economic recovery remains muted, California and its municipalities are turning to public-private partnerships (PPPs) as an efficient means of tackling vital public projects while limiting budgetary strain.

For example, in February 2009, the California State Legislature gave the State Department of Transportation and regional transportation agencies authorisation to enter into PPP concession arrangements without further legislative action. Two PPP projects that are a response to this broad legislative initiative are the proposed Presidio Parkway roadway in San Francisco and a proposed new courthouse in Long Beach.

While PPPs offer benefits to both the private and public entities participating, the picture is more complicated in California because its constitution prohibits certain public entities from taking on any indebtedness that exceeds the current year’s income and revenue without qualified electors approving the debt. Because this constitutional limitation generally precludes specified public entities from guaranteeing future payments, lenders and these government agencies face headwinds in structuring PPPs which contemplate long-term availability-based concession payments.  

Availability-based concession agreements provide for periodic payments by public entities in return for the private entity constructing, operating and maintaining a project in a manner that ensures availability for public use in accordance with specified criteria. Such concessions are a popular method to attract private capital to PPPs, because the sponsoring public entity can deliver a project without imposing new tolls or fees, or in any event without turning over to a private party the tolls and fees generated by the project. 

Such availability-based concessions are also attractive to private investors because the investor is entitled to payment from the public entity if it meets the specified availability criteria, regardless of whether public use of the project waxes or wanes. In evaluating an availability-based concession in California, however, participating parties must consider the potential effects of constitutional debt limitations.

A legacy of the 19th century

The California constitution states that “no county, city, town, township, board of education, or school district, shall incur any indebtedness or liability in any manner or for any purpose exceeding in any year the income and revenue provided for such year, without the assent of two-thirds of the qualified electors thereof” unless before the debt is incurred, the relevant public entity has funded the debt through a sufficient tax assessment. Initially, the California constitution only restricted the state’s obligations. The provision covering cities, counties and school districts was added in 1879.

In interpreting the meaning of the state and local restrictions, which courts have interpreted to be substantively the same, courts have focused on three purposes: (1) to safeguard the general funds and property of a governmental entity from a situation in which the holders of an issue of bonds could force an increase in taxes or foreclose on the entity’s general assets or property; (2) to afford taxpayers an opportunity to express their approval or disapproval of long-term indebtedness; and (3) to end extravagant public expenditures.

As historical efforts to modify or eliminate the provision have not been successful, the limitation presents complications for availability-based PPPs, where a public entity covered by the state constitutional restriction commits to provide a multi-year stream of payments to a private party in return for the construction of and, typically, operation and maintenance of, infrastructure that such entity could not afford to develop, operate and maintain on its own.

A common strategy to avoid the debt restrictions in California and other states has been to include a provision in multi-year contracts (including in concession agreements for PPP transactions) that payments in future years are subject to appropriation in future years’ budgets. Under this construct, investors accept the risk that the controlling body of the applicable public entity will continue to make the future payments, even though there is technically no legal obligation for the public entity to do so.

The financial markets (including both investors and rating agencies) have generally been receptive to this structure. It is understandably viewed as unlikely that public entities, which typically rely on the availability of private financing, will simply decline to appropriate sufficient funds when funds are otherwise available, because any such default will increase future borrowing costs, or even preclude the availability of future credit. But, as recently seen in Harrisburg, Pennsylvania, fiscal realities can result in a failure to appropriate. Thus, there may be substantial pricing benefits available to public entities where this risk can be taken off the table.

The meaning of indebtedness

PPPs are only impacted by the California constitutional limitation if they create indebtedness to a party that would exist beyond a given year. California courts have avoided a fixed definition of “indebtedness”, instead preferring a case-by-case, contextual approach, which has resulted in two lines of decisions.

First, courts have held that public entities entering into multi-year agreements, such as lease or construction contracts, incur “indebtedness” in a given year to the extent of the consideration received from the other party. In other words, if a private entity provides services on a yearly basis, then the debt would likely not be a future debt because the payments will be considered for services rendered during a given year. Second, where a party entering into a contract with a public entity has fully performed, the public entity incurs “indebtedness” to the full extent of its obligation under the contract.

For example, a transaction that transfers land to a municipality in exchange for yearly payments would comprise debt because the future payments arise from an obligation created by the private party in a prior year. 

As most concession-based PPPs involve multi-year payments to private entities, meeting the first part of “indebtedness”, a private party should consider the next set of questions to determine whether a particular concession payment arrangement is likely subject to California’s constitutional provision.

What kind of contract is proposed for the PPP?

Contracts from public entities subject to the debt limitation, and that stretch payments out to a private party over a number of years for work or services that have already been performed, generally run afoul of California’s constitutional limitations. In other words, amortising the cost of constructing a substantial infrastructure project is one kind of situation that courts have disapproved.

However, a contract with annual or more frequent payments generally might not violate the constitutional provision as long as the public entity is receiving some kind of consideration for each period payment is due. For example, lease-back arrangements are generally upheld. However, acceleration clauses that make the entire sum of future yearly payments due at once are impermissible because they create immediate indebtedness when the aggregate amount of installment rent is brought forward. If a public entity defaults, rent or amounts accelerated could only potentially be collected if the landlord brought an annual action for amounts which became due during such year.  

Though the issue has not yet been litigated, concession agreements for infrastructure projects that include the private party operating and maintaining the completed site might satisfy the judicial mandate for consideration provided in a given year, meaning that the public entity’s periodic payment to the private party would not invoke the constitutional provision’s bar. While contrary to the typical expectations of contracting parties (and their financiers), this approach could provide limited redress in the event of a public entity default. However, it is generally understood that most concessions under consideration in California contemplate substantial initial construction expenditures which are intended to be amortised over time, and thus may constitute indebtedness. 

What is the source of the funds used to make concession payments?

California courts have limited the indebtedness restrictions to instances where the applicable governmental entity’s general funds can be used to repay the obligation incurred. If only a special fund of money will be used to pay the obligation, however, that arrangement will not fall under the constitutional constraints. This exception is known as the special fund doctrine. For this exception to apply, the governmental body’s general fund cannot be liable directly or indirectly to pay the debt, even if there is a special fund shortfall. A government entity can, however, make discretionary payments from the general fund on a debt that falls within the scope of the special fund doctrine.

Examples of the special fund doctrine include: revenue bonds to construct improvements to a sewer system payable solely from sewer charges; water district bonds repayable only from water revenues; harbour revenues used to repay bonds for a city’s harbour improvements; and paying construction costs for a library building, which the city leased back from the private entity upon completion, out of a special fund into which the city made rental payments.

In short, a PPP concession payment structure in which the private party is paid out of a special fund established from specified charges that does not rely directly or indirectly on the public entity’s general fund to cover shortfalls, should generally fall outside of the California debt restriction provision.  

Which party is obligated to make the payment?

California courts have limited the constitutional restriction to the entities specified – entities that are not mentioned may not face the same limitations when incurring debt. For instance, irrigation, joint highway, utility districts, a board of trustees of a free public library, and a water and power commission have been found by California courts to be excluded from the constitutional prohibition.

Joint powers agencies, which are entities which are separate – and whose debts, liabilities and obligations are separate – from the relevant public entity, might also be able to incur debts beyond a given year without running afoul of California’s constitutional constraints. Local metropolitan transit districts are another example of agencies generally thought to be exempt form the constitutional debt constraints.  

These excepted entities have substantial opportunities to structure PPPs which are not expressly subject to appropriation risk in future years, and should have opportunities to attract private capital at favourable rates.

What kinds of contractual provisions may give the private party additional protection against a public entity default?
Even if a concession-based PPP requires multi-year payments which might otherwise violate the constitutional debt restriction, there are other contractual provisions that can mitigate the risks to the project. 

If the public entity prepares budget forecasts, a contract may require that its payments be included. For example, the public entity may contractually obligate itself to include the contract’s payments in its budget requests, fund estimates, and any budget adjustment proposals, and to do so in a timely manner so that the payments to the private party arrive on time as defined in the contract.

Similarly, while not the case in California, in some states the legislature prepares a multi-year budget forecast, which can include foreseeable payments resulting from PPPs or other third-party transactions.  While not offering absolute protection from failure to appropriate, such a mechanism ensures that the legislature maintains headroom in its budget over time in an amount sufficient to make the required concession payments.  

Also, to the extent such a provision is feasible and enforceable, a contract might require the public entity to prioritise payments under a particular project contract above other projects or future projects, as did certain PPP agreements considered in California. This provision offers strong practical protection from the risk that constituent demands might tempt a public entity that has entered into a long-term availability payment-based concession to forsake its payment obligations with respect to a completed project in order to fund new projects.

In short, although each contract must be viewed in light of its specific context, when structuring availability-based PPPs in California, the parties should consider the factors and contractual provisions discussed above in order to protect the interests of all parties and attract private capital at favourable rates.  ?

Warren Lilien is a partner in the New York office of law firm Latham & Watkins LLP; Ursula Hyman is a partner in the Los Angeles office of Latham & Watkins LLP

The authors wish to acknowledge the contribution of Howard Locker, a summer associate in Latham & Watkins’ New York office