|
 | |
|
Private Financing of Infrastructure in California: Overview of PPP Opportunities and Challenges
|
|
September 1, 2008
|
|
|
|
By W. Samuel Niece
Thelen LLP
California historically has relied on public monies to finance its infrastructure. The demand for infrastructure has increased dramatically as the state’s population has increased. However, the availability of public revenues to fund infrastructure has not kept pace.
Accordingly, cash-strapped governments are turning to the private sector for financing, design, construction, maintenance and operation of infrastructure projects. These arrangements often are referred to as public-private-partnerships (PPPs or P3s) or Private Finance Initiatives (PFIs).
PPP models (and their associated acronyms) include:
|  | Design-Build (DB).
|
| | Design-Build-Maintain (DBM).
|
| | Design-Build-Operate (DBO).
|
| | Design-Build-Operate-Maintain (DBOM).
|
| | Design-Build-Operate-Turnover (DBOT).
|
| | Concession (“public” utilities as opposed to “municipal” utilities).
|
When the private party provides financing, then an “F” sometimes is added to the acronym, such as DBFOM.
PPP involves two key issues: 1.) project deliver system; and 2.) extent of private financing.
The traditional approach to infrastructure was design-bid-build, with the public entity funding 100 percent of the design and construction (although sometimes with municipal bonds). Design-Build typically still employs 100 percent public funding. On the other hand, Design-Build-Operate-Maintain and concession projects typically involve partial or total private funding.
Design-Build
Commentators differ on whether design-build is the first step in PPP or the last step in owner-funded project delivery systems. 1/ Regardless, design-build is an essential element of almost all privately-funded infrastructure projects.
A useful way to look at design-build is by what it is not. Traditional design-bid-build is a segmented, sequential process in which the owner first contracts with a design professional to prepare detailed, suitable-for-construction plans and specifications (or sometimes has them prepared by its in-house design professionals), then uses the detailed plans and specifications to solicit competitive bids for construction, and finally awards the construction contract to the low bidder.
“In the Design-Build approach to project delivery, the owner contracts with a single entity – the designer-builder – for both design and construction.” 2/ California Government Code §14661 (b) and California Public Contract Code §20133 (c)(2) define the term as “a procurement process in which both the design and construction of a project are procured from a single entity.” Typically, the design-build contract is awarded by some process other than low-bid competitive bidding. California Government Code §14661 (d)(3)(a)(i) provides that “[a]ward shall be made to the design-build entity whose proposal is judged as providing the best value in meeting the interest of the department and meeting the objectives of the project.” Public Contract Code §20133 provides that “[a] county may use a design-build competition based upon best value...” and defines “best value” to include “price, features, functions [and] life-cycle costs.”
Thus, design-build differs from traditional design-bid-build in two ways. First, the design and construction components are packaged into a single contract. Second, the single contract is not necessarily awarded to the low bidder after competitive bidding.
The term “design-build” generally is applied to design and construction of buildings. The term “Engineer, Procure, Construct” (EPC) generally is applied to design and construction of power and process plants. Most of this discussion applies equally to design-build and EPC.
| B. | Potential Advantages of Design-Build
|
Cost Savings: Design-build has the potential to reduce overall project cost because the design-build contractor performing the design has a better feel for the construction cost of design alternatives and thus can come up with a design that is less expensive to build – and has an incentive to do so. Another way to look at this advantage is that it moves value engineering (or “cost reduction incentive”) from after contract award (with the contractor proposing cost-reduction ideas and sharing the savings with the owner) to pre-award (with the owner enjoying most of the cost savings).
Earlier Project Completion: Design-build may result in earlier completion and occupancy of the project because there is no dead time between completion of design and start of construction. Further, the design-build contractor can begin construction of early phases of the project (e.g., grading, site utilities, foundations) before design of later phases (building envelope, interior partitions, HVAC, electrical) is 100 percent complete. This process sometimes is referred to as “fast track.”
New Technologies: Public Contract Code §3400 prohibits brand-name or model-number specifications for California public projects unless the specification lists at least two brand names and is followed by the phrase “or equal.” This makes it difficult for traditional design-bid-build to reach innovative, proprietary products – for which there may be only one brand name and no equal. Further, substitution of a new “or equal” product for a standard product often is impracticable because of the ripple effect. The designer designs the project around current generation products, and substitution of new “or equal” products after bidding can require revisions to structural, mechanical or electrical components to accommodate the new product. Who is going to pay for these ripple changes? Design-build resolves this problem. The design-build entity selects the equipment (right down to make and model number) and then designs the building around the selected equipment, which is a more logical way to proceed. In fact, the design-build entity sometimes can obtain free design assistance from equipment manufacturers desiring that their new technologies be used.
Overall Project Optimization: Design-bid-build can suffer from sub-optimization when individual project participants optimize their own positions, often at the expense of the overall project. The total cost to the owner of a building element, such as the steel frame, includes the cost of the engineering to determine the required steel sections plus the cost of the steel. The designer has little incentive to use a sharp pencil to achieve the minimum amount of structural steel; he optimizes his own position by spending only the design time necessary to ensure that there is enough steel to meet gravity and seismic loads, often by employing conservative assumptions that may result in more steel than necessary. So, the owner may save money on design but pay for it in steel.
With design-build, on the other hand, the design-build entity has an incentive to use the optimum amount of engineering. As long as an additional dollar of engineering will save more than one dollar’s worth of steel, the design-build contractor will spend the engineering time up to the point of diminishing returns when an additional dollar’s worth of engineering saves only a dollar’s worth of steel because both the cost of design and the cost of steel come out of the same pocket.
This is not to say that design-build results in flimsy or less-safe structures. “More” (steel, concrete, etc.) is not necessarily “better.” Simply specifying extra steel or concrete in one place because the engineer does not have the time or incentive to calculate exactly how much is actually required does not improve the overall performance of the building. “A chain is only as strong as its weakest link.” If the owner wants a building with higher floor loadings, less floor deflection or resistance to a bigger earthquake than required by code, then the way to achieve this is by placing that requirement on the design-build entity up front – not by hoping that the designer will throw in some extra steel or concrete because he or she does not have time in the budget to use a sharp pencil.
This advantage becomes even more pronounced in DBOM, where the private entity will bear the costs of operating and maintaining the facility. The private entity can be expected to put more money into construction where it will reduce operation and maintenance costs and vice versa. For example, a private entity with a 35-year DBOM contract might opt for a slate roof that would last the full 35 years rather than an asphalt shingle roof that it might have to replace twice during the life of the PPP agreement.
Reduced Administrative Burden: Design-build may reduce the administrative burden on the owner because there is one solicitation, one award and one contract to administer. On the other hand, PPP agreements are complex and may require more time and money to negotiate than traditional design and construction contracts.
Earlier Cost Visibility: The total cost of the project is apparent earlier with design-build. In traditional design-bid-build, construction costs are not known until bid opening, and it is possible to spend money (and time) on a design that the owner cannot afford to build. All too often, construction bids exceed the budget, and the project must be re-designed to bring it within the budget, thus delaying completion.
| C. | California’s Historical Hostility to Design-Build
|
In general, the mode prescribed for public contracts is traditional design-bid-build, and the California Supreme Court long ago rejected design-build for public projects:
To permit each bidder to propose the plans and specifications according to which he will construct the building, not only prevents competition in bidding for the work, but gives to the board an opportunity for the exercise of favoritism in awarding the contract, instead of being required to let it to the lowest responsible bidder; for, since neither of the bidders can know of the plans and specifications under which others are making their bids, there is no standard by which the board can determine which is the lowest responsible bidder.
Ertle v. Leary, 114 Cal. 238 (1896).
The Supreme Court’s antagonism toward design-build has found its way into the statutes governing contracting by California counties:
| | Public Contract Code §20124: “The board of supervisors shall adopt plans, specifications, strain sheets, and working details for the work.”
|
| | Public Contract Code §20127: “All bidders shall be afforded opportunity to examine the plans, specifications, strain sheets, and working details.”
|
| | Public Contract Code §20128: “The board shall award the contract to the lowest responsible bidder, and the person to whom the contract is awarded shall perform the work in accordance with the plans, specifications, strain sheets, and working details....”
|
Those statutes describe traditional design-bid-build. Thus, they prevented counties from using design-build and provided the impetus for enactment of Public Contract Code §20133, which allows specified counties to use a specified variety of design-build, which is similar to the Government Code §14661 process for state office buildings. 3/ (That the California Legislature found it necessary to enact Public Contract Code §20133 to enable designated counties to use “best-value” design-build reinforces the conclusion that other counties do not have authority to use design-build and that the designated counties have authority to use only the cumbersome process set forth in §20133.)
The Public Contract Code §20133/Government Code §14661 process is somewhat similar to the design-build process employed by the federal government.
Unlike California, though, the federal government generally has been receptive to design-build. In 1994, a coalition of design and construction industry associations met with the General Services Administration and the Army Corps of Engineers, resulting in passage of the Clinger-Cohen Act of 1996, which is codified at 41 USC 253m and implemented by Federal Acquisition Regulation (FAR) Subpart 36.3.
Clinger-Cohen calls for a two-phase procedure:
| | Phase One is open to all comers and deals with experience and technical competence.
|
| | In Phase Two a limited number of offerors (five or fewer) submit detailed concepts and pricing.
|
| | Award is made based on price and other factors – not necessarily the lowest-priced proposal – in accordance with evaluation factors set forth in the Request for Proposals.
|
Unlike Clinger-Cohen, Public Contract Code §20133 and Government Code §14661 call for a single-phase procedure, with all comers submitting detailed proposals. Either the state or a county can pre-qualify offerors, in which case the §20133/§14661 process comes closer to Clinger-Cohen although the state or county has to allow all qualified firms to submit offers – as opposed to Clinger-Cohen’s procedure for narrowing the offerors to a manageable number based on experience and technical competence.
There are two types of California cities: general law and charter. Construction contracting by general law cities is governed by Public Contract Code §20162, which provides that “[w]hen the expenditure required for a public project exceeds five thousand dollars ($5,000), it shall be contracted for and let to the lowest responsible bidder after notice.” But what is not set forth in §20162 is more important than what is there. There is no requirement analogous to Public Contract Code §§20124, 20127 and 20128 for plans, specifications and working details to be available for examination by the bidders or for the contractor to perform the work in accordance with such plans, specifications and working details. It appears, therefore, that in principle a general law city can contract for public works based on less than 100 percent plans and specifications, i.e., procure both the design and construction of a project from a single entity, which is design-build. However, there does not appear to be any universally-applicable statutory authorization for general law cities to do “best value” or competitively negotiated procurement, so such design-build contracts would have to be awarded to the low bidder. Thus, a general law city probably cannot realize the full potential of design-build, but design-build nevertheless may be a viable alternative for certain projects.
There is, of course an exception: Public Contract Code §20175.2 authorizes “cities in the Counties of Solano and Yolo and the Cities of Stanton and Victorville” to use best-value design-build. 4/
Charter cities are not bound by state law (including the Public Contract Code) on “municipal affairs,” and public works contracting is a municipal affair, generally governed by a charter city’s charter and municipal code rather than state law. Associated Builders and Contractors v. San Francisco Airports Commission, 21 Cal.4th 352 (1999). Thus, a charter city can do best-value design-build if its charter and municipal code so authorize. Some charter cities, such as Los Angeles, have enacted charter or code provisions permitting design-build. Other charter cities, such as Santa Clara, simply have adopted competitive bidding language substantively identical to Public Contract Code §20162.
So, when dealing with a California city, the first step is to determine whether the city is general law or charter. If general law, look to Public Contract Code §20162 (unless it is Stanton or Victorville or one of the cities located in Solano or Yolo County, in which case look to Public Contract Code §20175.2). If charter, look to the city charter and municipal code (which usually are available on the city’s Web site).
Or, consider the California Infrastructure Financing Act (Government Code §§5956, et seq.), discussed below.
Lease and Lease-Back: The Original PPP Vehicle
Several California local governments, most notably Los Angeles County, have used lease and lease-back transactions since the 1940s. In the typical lease and lease-back transaction, the governmental entity owns a parcel of land that it leases to a private entity. The private entity then builds a facility on the land and leases the land improved with the facility back to the governmental entity. Statutory authorization for such transactions is found at Government Code §§25371, 25351 and 25351.3 (counties) and Education Code §§17403 to 17414 (school districts).
Such transactions have been challenged in court on the theory that they are merely subterfuges to evade the multi-year limitation of California Constitution Article XVI, §18 [“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 voters….”]. The courts have rejected such challenges. City of Los Angeles v. Offner, 19 Cal.2d 483 (1942); Los Angeles County v. Byram; 36 Cal.2d 694 (1951); Dean v. Kuchel, 35 Cal.2d 444 (1950); Rider v. San Diego, 18 Cal.4th 1035 (1998); County of Los Angeles v. Nesvig, 231 Cal.App.2d 603 (1965); Ruane v. San Diego, 267 Cal.App.2d 548 (1968); 56 Ops.Cal.Atty.Gen. 571 (1973).
It remains an open question whether lease and lease-back transactions must be competitively bid. The public contract competitive bidding laws apply to “public works contracts,” i.e., “agreement[s] for the erection, construction, alteration, repair, or improvement of any public structure, building, road, or other public improvement of any kind.” Public Contract Code §1101. In Boydston v. Napa Sanitation District, 222 Cal.App.3d 1362 (1990), the court found a lease to be within the statutory definition of a public work, to which the competitive bidding laws apply. Nevertheless, many lease and lease-back transactions have been negotiated rather than competitively bid, apparently without court challenge. Thus, governmental entities or private parties considering negotiated lease and lease-back transactions should consider validation, as discussed below.
California Infrastructure Financing Act
The California Infrastructure Financing Act (IFA) of 1996 (codified at Government Code §§5956, et seq.) has its roots in 1989 legislation that enacted Streets and Highways Code §143, authorizing the California Department of Transportation (Caltrans) to enter into agreements with private entities for four privately-funded toll road demonstration projects.
A.
| Streets and Highways Code §143
|
There actually are two Streets and Highways §143s: The first was enacted in 1989 and expired on January 1, 2003, and the second was enacted in 2006 and runs through 2011.
In enacting the first Streets and Highways §143, the legislature found that:
Public sources of revenues to provide an efficient transportation system have not kept pace with California’s growing transportation needs, and alternative funding sources should be developed to augment or supplement available public sources of revenue.
One important alternative is privately funded Build-Operate-Transfer (BOT) projects whereby private entities obtain exclusive development agreements to build, with private funds, all or a portion of public transportation projects for the citizens of California.
Accordingly, Caltrans was authorized to:
solicit proposals and enter into agreements with private entities, or consortia thereof, for the construction by, and lease to, private entities of four public transportation demonstration projects, at least one of which shall be in northern California and one in southern California.
In response, Caltrans solicited proposals for demonstration projects, selected four entities and entered into contracts as follows:
| | California Toll Road Co. (CTRC) for an 85-mile expressway between Sunol and Vacaville (the Mid-State Tollway).
|
| | National Toll Road Authority Corp. for an 11-mile extension of Route 57 in Orange County utilizing the Santa Ana Flood Control Channel.
|
| | California Private Transportation Corp. for an 10-mile, four-lane road in the median of Route 91 from the Riverside County line to Route 55 in Orange County.
|
| | California Transportation Ventures, Inc. for a 10-mile limited access highway in San Diego County (the South Bay Expressway, State Route 125).
|
The Professional Engineers in California Government (PECG – the Caltrans engineers union) immediately sued in San Francisco Superior Court to block the agreements. PECG lost at both the trial and appellate levels, and the California Supreme Court denied review. 5/
Even after the litigation was resolved in Caltrans’ favor, only two of the four projects were built, and only one of these still is operated as a PPP.
The Mid-State Tollway encountered serious political opposition, and the agreement was terminated in 2001.
The private entity requested that the date for start of construction for the State Route 57 (Santa Ana Flood Control Channel) project be slipped from 2001 to 2007. Caltrans denied the request, and the agreement was terminated in 2001, resulting in litigation that was resolved in 2003.
The State Route 91 (Median Express Lanes) project was completed and opened to traffic in 1995. However, it generated substantial controversy over the non-compete clause in the PPP agreement, which provided that Caltrans could not enter into a similar PPP agreement or itself construct any parallel lanes within 1½ miles on either side of the new express lanes. This clause was necessary in order to attract private capital, but once the new lanes were in place, opposition developed, with Riverside County suing Caltrans and the PPP consortium. In addition, the majority owner of the consortium lost interest in the toll road business.
In 2000, a nonprofit entity (NewTrac) was formed to issue tax-exempt bonds and buy out the project, but then-Attorney General Lockyer torpedoed that deal.
Eventually, the legislature enacted AB 1010 in 2002, which authorized the Orange County Transportation Authority to issue bonds and buy out the project, effectively repealing the non-compete clause and enabling Caltrans to add parallel lanes. So, this has not been a PPP since 2003.
The South Bay Expressway (State Route 125) project was completed and opened to traffic in November 2007 and still is operated as a PPP.
Subsequent Amendments to Streets and Highways §143: In 2002, the legislature amended Streets and Highways §143 to preclude Caltrans from entering into any new demonstration projects after January 1, 2003. 6/
Then, in 2006 the legislature re-opened the spigot, authorizing four more “transportation projects,” “primarily designed to improve goods movement, including, but not limited to, exclusive truck lanes and rail access and operational improvements.” 7/ The legislature initially required that PPP agreements had to be approved by legislature, but this was changed to provide that the agreements merely had to be submitted to the legislature, and the agreements would be deemed approved unless the legislature specifically disapproved them within 60 days. 8/
B.
| IFA (Government Code §§5956, et seq.)
|
In 1996, the Consulting Engineers and Land Surveyors of California (CELSOC) sponsored and Assemblyman Aguiar introduced as AB 2660 a bill which:
would authorize state and local governmental agencies to enter into an agreement with a private entity for the design, construction, or reconstruction by, and lease to, that entity of a revenue generating infrastructure project, as specified.
PECG (the Caltrans engineers union) opposed the bill, so “state” was deleted from the preamble:
This bill would authorize local governmental agencies to enter into an agreement with a private entity….
And, a final subsection was added:
Notwithstanding any provision of this chapter, neither the state or any state agency may directly or indirectly use the authority of this chapter, nor may any governmental agency as defined in Section 5956.3, use the authority of this chapter, to design, construct, finance, or operate a state project. For the purposes of this section, a state project includes any of the following:
(a) Toll roads on state highways.
(b) State water projects.
(c) State park and recreation projects.
(d) State financed projects.
These limitations shall not prohibit the state, any state agency, or any governmental agency as defined in Section 5956.3, from utilizing authorizations contained in other provisions of law.
Key provisions of IFA include:
Applicability: IFA applies to local governmental entities (general law cities, charter cities, counties, school districts, joint powers authorities, transportation authorities) but not to Caltrans or any other state agency. (Government Code §§5956.1, 5956.3.)
Discretionary: IFA supplements existing authority rather than limits, replaces or detracts from existing authority. Local governmental entities are free to use it or not as they see fit. (§5956.2.)
Fee-producing Infrastructure: Projects must be “fee-producing,” i.e., they must be “revenue-generating.” (§§5956.1, 5956.4, 5956.6(4), AB 2660 Legislative Counsel’s Digest.)
Reversion to Governmental Agency at End of Agreement Term: An IFA agreement may be for a term of up to 35 years, at the end of which the infrastructure reverts to the governmental agency. (§5956.6(a).)
Competitive Bidding Not Required: “The contractor is selected pursuant to a competitive negotiation process… utiliz[ing], as the primary selection criteria, the demonstrated competence and qualifications for the studying, planning, design, developing, financing, construction, maintenance, rebuilding, improvement, repair, or operation, or any combination thereof, of the facility… [and] shall not require competitive bidding.” (§5956.4.)
Exemption from Many Public Contracting Requirements: California law requires that public contracts include provisions relating to, among other things:
| | Prevailing wages (Labor Code §1770).
|
| | Working hours (Labor Code §1810).
|
| | Worker’s compensation insurance (Labor Code §§3700, 1860, 1861).
|
| | Payment bonds (Civil Code §§3247, 3248).
|
| | Contractor licensing (Business and Professions Code §7028.15).
|
| | Trench safety (Labor Code §6705).
|
| | Contract based on complete plans and specifications (Public Contract Code §§20124, 20127, 20128).
|
| | Claims of $375,000 or less (Public Contract Code §§20104).
|
| | Escrow of retention (Public Contract Code §22300).
|
| | Antitrust claim assignment (Public Contract Code §7103.5).
|
| | Non-collusion affidavit (Public Contract Code §7106).
|
| | Subcontractor listing (Public Contract Code §4100).
|
| | Differing site conditions (Public Contract Code §7104).
|
| | Audit (Government Code §8546.7).
|
| | Utility relocation (Government Code §4215).
|
In addition, several contract provisions are prohibited in public contracts, including:
| | Restrictions on indemnification (Civil Code §§2782, 2782.8).
|
| | Absolute power to decide disputes (Civil Code §1670).
|
| | Waiver of claims (Public Contract Code §7100).
|
| | No damage for delay (Public Contract Code §7102).
|
| | Tidal wave and earthquake liability (Public Contract Code §7105).
|
| | Brand-name specifications (Public Contract Code §3400).
|
IFA §5956.5 does require compliance with Government Code §87100 (“No public official at any level of state or local government shall make, participate in making or in any way attempt to use his official position to influence a governmental decision in which he knows or has reason to know he has a financial interest”) and then continues:
Other than these criteria and applicable provisions related to providing security for the construction and completion of the facility, the governmental agency soliciting proposals is not subject to any other provisions of the Public Contract Code or this code that relates to public procurements.
“This code” refers to the Government Code, so §5956.5 appears to exempt IFA agreements from the public procurement requirements of the Public Contract Code and the Government Code. Note, however, that there is no exemption from requirements codified elsewhere, such as in the Labor Code, Civil Code, or Business and Professions Code.
Note also the reference to “provisions related to providing security for the construction and completion of the facility.” This is a vestige of the original draft of IFA, when it included the state. Under Public Contract Code §§10221 and 10224: “Every contract shall provide for the filing of separate performance and payment bonds” and “[t]he performance bond shall guarantee the faithful performance of the contract by the contractor.” However, §§10221 and 10224 are in the State Contract Act part of the Public Contract Code. There is no similar requirement in the Local Agency Public Construction Act part.
Thus, §5956.5 appears to exempt IFA agreements from several problematic requirements of the Public Contract Code, such as competitive bidding, subcontractor listing, prohibition of brand-name specifications, but not statutes in other codes.
California Environmental Quality Act: IFA projects eventually must comply with the California Environmental Quality Act (CEQA, Public Resources Code §§21000, et seq.). An environmental impact report (EIR) is not required for selection of the private entity or execution of the PPP agreement, but the private entity must prepare the EIR before “project development commences.” (Government Code §5956.6(b)(1); Concerned Citizens Coalition of Stockton v. City of Stockton, 128 Cal.App.4th 70 (2005).)
Performance Bond or Alternatives: The IFA requires that the PPP agreement include “security for the construction of the facility to ensure completion, and contractual provisions that are necessary to protect the revenue streams of the project.” (Government Code §5956.6(b)(2).) This probably can be either a performance bond or a letter of credit.
Limitation on Use of User Fees: User fees generated by the project cannot be siphoned off to the general fund:
User fee revenues shall be dedicated exclusively to payment of the private entity’s direct and indirect capital outlay costs for the project, direct and indirect costs associated with operations, direct and indirect user fee collection costs, direct and indirect costs of administration of the facility, reimbursement for the direct and indirect costs of maintenance, and a negotiated reasonable return on investment to the private entity
(§5956.6(b)(4).)
No local agency shall levy a new fee or service charge or increase an existing fee or service charge to an amount that exceeds the estimated amount required to provide the service for which the fee or service charge is levied and a reasonable rate of return on investment, pursuant to paragraph (4).
(§5956.6(b)(5)(D).)
Public Hearings Required to Set User Fees: The public entity must conduct public hearings before setting or increasing user fees for the project. (§5956.6(5).)
Audit: The private entity must prepare annual audit reports and make them available to the public. (§5956.6(7).)
Dispute Resolution: IFA §5956.6(b)(12) provides: “In the event of a dispute between the governmental agency and the private entity, both parties shall be entitled to all available legal or equitable remedies.” This could be construed as limiting the parties’ freedom to provide for binding arbitration in the agreement. However, under California Code of Civil Procedure §1281: “A written agreement to submit to arbitration an existing controversy or a controversy thereafter arising is valid, enforceable and unrevocable.” In Cary v. Long, 181 Cal.443, 448 (1919), the California Supreme Court held that Code of Civil Procedure §1281 applies to municipal corporations. As to the potential conflict between IFA §5956.6(b)(12) and Code of Civil Procedure §1281, the Legislature demonstrated in IFA §5956.5 that it knew how to exempt IFA agreements from otherwise-applicable statutes, so its silence with regard to Code of Civil Procedure §1281 can be construed as an intent not to remove IFA agreements from the arbitration provisions of §1281. However, no court has spoken on this question, so it remains debatable.
Utilities Relocation: Utilities relocation costs are to be borne initially by the private entity as a recoverable capital cost. (§5956.7.)
Design Standards: IFA projects must comply with “all applicable governmental design standards for that particular infrastructure project.” (§5956.8.)
Allowable Funding Sources: IFA projects can be fully funded by the private entity or by a combination of private, federal and local funds. (§5956.9.) State funds cannot be used. (§5956.10(d).)
California’s original PPP statute (the 1989 version of Streets and Highways §143) was one page. The 2006 version of Streets and Highways §143 is three pages. The 1996 IFA is seven pages. The extra verbiage consists primarily of restrictions and requirements that make PPPs more difficult to implement and thus less attractive.
Canadian Experience
PPPs originated in Europe and spread to Australia and Canada – British Columbia in particular.
In December 2007, Gov. Swarzenegger’s office began using the acronym “PBI” (Performance Based Infrastructure) to champion increased use of PPPs in California.
There has been a substantial increase in the use of PPPs in Canada in the last decade. In British Columbia, a new organization, Partnerships British Columbia (PBC), was created in 2002 to advance PPPs. PBC purports to be a private company, but it is wholly owned the British Columbia Ministry of Finance. 9/
In California AB 1756 was introduced on January 7, 2008:
This bill would require the Secretary of Business, Transportation and Housing to establish the Office of Local Public-Private Partnerships in the agency to inform local agencies and other interested stakeholders of the role that public-private partnerships can play in financing, constructing, or operating, or any combination thereof, fee-producing local infrastructure projects.
This appears to be modeled after British Columbia’s PBC. In addition, Governor Schwarzenegger has proposed:
| | Expanding the types of projects, services and government entities that can enter into PBI arrangements.
|
| | Establishing “PBI California,” a center for excellence to help determine which state projects can benefit from PBI, represent the state in negotiations with PBI participants, to ensure transparency and to monitor performance. The governor says the center will empower California to build, operate and maintain infrastructure better, faster and for less.
|
| | A $2 billion bond issue for courthouse construction that will be leveraged with PBI financing to speed delivery, expand the number of projects and improve courthouse maintenance. 10/
|
Because the state does not have broad authority for PPPs and courthouses are state facilities, the governor is likely to run into opposition from PECG on the court plan.
Risks in Private Funding (and How to Mitigate Them)
A.
| Risks to Both Parties in a PPP
|
Examples include:
| | PECG’s 1990 action to block the original four Streets and Highways §143 toll-road demonstration projects. 11/
|
| | Genevieve Graydon’s 1978 action to block construction of a parking garage under a redevelopment project in Pasadena. 12/
|
| | Concerned Citizens Coalition of Stockton’s 2003 action to block privatization of operation and maintenance of Stockton’s wastewater, water and stormwater utilities. 13/
|
The Void Contract Rule: The power of a public agency to contract is prescribed by law, and a contract made in disregard of the prescribed mode is void. 14/
Thus, if the PPP is not made in accordance with the requirements of IFA (or other applicable statute), then a court could find the PPP agreement void. When a court finds a contract void, it is void ab initio (from the beginning), not just prospectively. Thus, there can be no contractual recovery for anything either side has done. If the agreement is declared void, not only can neither side enforce it, but there is no implied liability on the part of the public entity for the reasonable value of services rendered. 15/ A void PPP would be a real mess. From the public entity’s viewpoint, the project would be dead in the water. From the private entity’s viewpoint, it could be out of pocket capital expenses with no way to recover them.
In the Graydon case, a contract for a parking garage came into existence in November 1977. A taxpayer brought a legal action seeking a declaration that the contract was illegal and prohibiting the public owner from disbursing funds in accordance with the contract. The trial court denied relief, and the taxpayer appealed. The appeals court affirmed the trial court but not until March 1980. By then, the garage was 80 percent complete. Fortunately, the appeals court denied relief, but if the case had gone the other way, the public agency would have been barred from paying the developer, and the developer could not have been compelled to complete the garage.
Validation: As a California Court of Appeal observed:
The fact that litigation may be pending or forthcoming drastically affects the marketability of public bonds…. We feel that the possibility of future litigation is very likely to have a chilling effect upon potential third party lenders, thus resulting in higher interest rates or even the total denial of credit. 16/
Fortunately, there is a way to mitigate the risk that an agreement will be found void or that the threat of litigation will result in higher interest rates. California Code of Civil Procedure §§860, et seq., provides that a public agency may bring an action to determine the validity of certain transactions. The Code of Civil Procedure merely sets up the procedure for conducting a validation action – there also must be a substantive law authorizing use of the procedure. In the case of California local public agencies, the authorization is found at California Government Code §§53510 and 53511:
As used in this article “local agency” means county, city, city and county, public district or any public or municipal corporation, public agency or public authority.
A local agency may bring an action to determine the validity of its bonds, warrants, contracts, obligations or evidence of indebtedness….
There really are two types of validation procedures: A validation procedure initiated by the public agency pursuant to Code of Civil Procedure §860 and a challenger-initiated anti-validation procedure (sometimes referred to as an “inverse validation action”), which is subject to a 60-day bar under §863. Under §869, the challenger must bring an action within 60 days or be forever barred.
Thus, a public agency can do nothing, wait 60 days and then relax if no action has been filed challenging the contract. So, why go to the trouble of initiating a validation action under §860? Because under §860 the agency can get two rulings from the court: 1) that the contract is the kind covered by the validation statutes; and 2) that the contract is valid. If the agency does not bring a §860 action, then a late-filing challenger will argue that the contract is not of the type covered by the validation statutes. For example, in the Graydon case, the Pasadena RDA awarded the contract on November 2, 1977, but Ms. Graydon did not file her court challenge until January 26, 1978 – more than 60 days later. Ms. Graydon argued that the challenged construction contract was not the type of “contract” contemplated by Government Code §53511, the validation procedure of §§860 through 869 was not applicable and, therefore, the 60-day bar did not apply. The trial court and the appeals court disagreed with Ms. Graydon, finding that the contract at issue was the type of “contract” contemplated by §53511 and that Ms. Graydon’s challenge was barred by the 60-day limitation of §§860 and 863.
The key question in Graydon was the scope of “contract” as used in §53511. Interpretation of the word in court decisions ranges from the very narrow – that “contract” is synonymous with “bonds, warrants, obligations of indebtedness” – to the broader interpretation that “contracts” encompasses construction contracts. An example of the narrow interpretation is found in City of Ontario v. Superior Court, 2 Cal.3d 335 (1970), in which a taxpayer challenged Ontario’s bond funding and sole-source contracting for the Ontario Motor Speedway. The taxpayer did not serve his complaint in the manner prescribed by the validation procedure until 88 days after contract award. Ontario argued that §53511 made §§860, et seq. applicable so that the taxpayer’s action was time-barred. The taxpayer argued that §53511 did not apply because “contract” meant “bonds.” The California Supreme Court observed that the legislative history of §53511 characterized the measure as allowing “a local agency to bring an action to determine the validity of evidences of indebtedness” and that this does not include “contracts.”
Graydon is at the other end of the spectrum. The Pasadena RDA awarded Ernest W. Hahn a sole-source, negotiated contract for a publicly-owned parking garage to be built under a retail center built on air rights over the garage. The court found that if completion of the retail center was delayed because of a delay in construction of the parking garage, the RDA would not be able to pay for its bond, which were dependent upon tax increment monies from the retail center. The bonds were “intimately and inextricably bound up with the award of the [garage construction] contract. Delay in the completion of the retail center because of the delay which would have inevitably resulted if the [garage construction] contract had been competitively bid and would have had a direct bearing on the financial ability of Agency to meet its financial obligations and statutory purpose.”
IFA agreements are financial in nature and are necessary for California local government agencies to meet their statutory purposes, they most likely are subject to validation under the Graydon precedent.
Nevertheless, there are pros and cons to validation.
Pro: If a court accepts a validation action and rules that the PPP agreement is valid, then there is little risk of a subsequent successful legal challenge. If the public entity commits to a validation action early in the negotiation process, this may give comfort to the lenders and reduce the interest rate that the private entity will have to pay.
Con: Filing a validation action may smoke out opposition. Someone with an inclination to challenge the project may be prodded to file an opposition in the validation action while the person might miss the 60-day time limit for a reverse validation action if the public entity does not bring a validation action. There also is the possibility that the court will find the transaction is not valid.
Whether a validation action is filed or not, project participants need to build at least 60 days of stand-still time into the schedule to allow for time to run on a reverse validation action before the private party commits substantial resources to the project.
PPP agreements are expensive for both the public entity and the private entity.
A PFI transaction is one of the most complex commercial and financial arrangements which a procurer is likely to face. It involves negotiations with a range of commercial practitioners and financial institutions, all of whom are likely to have their own legal and financial advisors. Consequently, procurement timetables and transaction costs can be significantly in excess of those normally incurred with other procurement options. 17/
B.
| Risks for the Public Entity
|
“Off-book financing” is a procedure under which a subsidiary entity has separate assets, debts and cash flow from the parent company. Enron went bankrupt using off-book financing, and credit-rating agencies have become increasingly attentive to and critical of off-book financing by private holding companies. 20/
Recently, credit-rating agencies have begun to view some PPP projects as off-book financing by the government agency and to treat PPP debt as government debt. 21/ This may result in a lowering of the government agency’s credit rating, which could lead to higher interest cost for government debt.
While PPPs may make it possible to bring an infrastructure project on line years earlier than under conventional government bond-funded approaches, a PPP in the United States is likely to cost more in the long run.
Tax-Free Government Bonds: In California, the interest paid on most state and local government bonds is exempt from federal income taxes and from California personal income taxes. 22/ On the other hand, private entity debt usually is fully taxable, so the private entity typically must pay a higher interest rate than would a public entity. For the deal to make sense, the public entity (or the users) eventually must reimburse the private entity for this higher cost of debt through higher user fees.
PPP proponents argue that private entities with experience in building and operating a particular type of infrastructure can do so more efficiently than a governmental entity with limited experience, and this may be so, but it takes a lot of subjective increased efficiency to make up for the objective interest advantage of tax-exempt government-issued bonds. 23/
The preceding discussion, however, views things from the narrow perspective of the local governmental entity. If the view is broadened and the transaction is examined from the perspective of government at all levels (local, state and federal), then perhaps the higher interest to pay the bond investors’ tax bills is not so much of a factor because the extra interest results in tax revenues to some governmental entity and thus presumably funds some public good.
Nonprofit Corporations: Certain nonprofit corporations can issue tax-exempt bonds under certain conditions. These include “63-20 corporations.”
Obligations issued by a nonprofit corporation formed under the general nonprofit corporation law of a state for the purpose of stimulating industrial development within a political subdivision of the state will be considered issued 'on behalf of' the political subdivision, for the purposes of section 1.103-1 of the Income Tax Regulations, provided each of the following requirements is met: (1) the corporation must engage in activities which are essentially public in nature; (2) the corporation must be one which is not organized for profit (except to the extent of retiring indebtedness); (3) the corporate income must not inure to any private person; (4) the state or a political subdivision thereof must have a beneficial interest in the corporation while the indebtedness remains outstanding and it must obtain full legal title to the property of the corporation with respect to which the indebtedness was incurred upon retirement of such indebtedness; and (5) the corporation must have been approved by the state or a political subdivision thereof, either of which must also have approved the specific obligations issued by the corporation. Interest received from such obligations is excludable from gross income under the provisions of section 103(a)(1) of the Internal Revenue Code of 1954. 24/
An example is the Pocahontas Parkway PPP in Virginia. Although the project was developed by a limited liability company, a 63-20 corporation (Pocahontas Parkway Association) was formed to issue tax-exempt bonds to finance the project. The LLC was compensated for design and construction from the bond proceeds. 25/
| 3.
| Default or Other Early Termination
|
The private entity in a PPP project almost always is a special purpose-entity/vehicle (SPE or SPV) that exists only for one project. If the project goes badly, the SPE can go bankrupt, requiring the governmental entity to step in and cover remaining costs in order to keep the project in operation. 26/
One of the justifications cited by proponents of PPPs is that the private entity takes on risks that otherwise would be borne by the government. However, this risk transfer may be illusory, as the private entities and their lenders frequently push back. 27/ An example is demand risk. With Streets and Highways §143 toll roads, the private entities assumed the risk that usage would be lower than projected but insisted on non-compete provisions in the PPP agreements. Another example is the Pocahontas Parkway in Virginia, where the Virginia DOT agreed not to “initiate, authorize, franchise or finance” any other highway crossing the James River within 3 miles of the project’s bridge crossing. 28/
But, in light rail privatizations, the private entities may be unwilling to assume ridership risk, so the public entity may make availability payments to the private entity rather than having the public entity bear the risk that ridership will be below projections. 29/
The complexity of PPPs and the cost of negotiating them reduces competition. PPPs with only two or three candidates are not uncommon. The Abbotsford (British Columbia) Hospital PPP project initially attracted four potential private entities, but three dropped out, leaving the province to negotiate with a single entity. 30/
C.
| Risks for the Private Entity
|
| 1.
| Changes in Political Leadership
|
Tom Bradley served as mayor of Los Angeles from 1973 to 1993. In 1986, the city decided that it needed additional office space for city employees. In 1987, the city’s Chief Administrative Officer issued an RFP to developers for a project to be called “First Street North,” consisting of an office tower for the city’s use plus commercial, residential, community and retail space to be built on 11 acres of city-owned land between the Civic Center and Little Tokyo. In 1988, the city council entertained proposals from three developers and authorized the CAO to enter into exclusive negotiations with First Street Plaza Partners for development of the site. 31/
Over the next several years, the developers say they expended more than $12 million on environmental impact reports and other land use and environmental review procedures.
On July 31, 1993, Tom Bradley was succeeded by Richard Riordan, and in 1994 the city decided not to go forward with the project and terminated negotiations with the developers. They sued to recover out-of-pocket expenditures of $12 million.
The trial court granted summary judgment in favor of the city on the grounds that contract formation requirements of the city’s charter had not been satisfied, and the Court of Appeal affirmed.
Thus, it is important to ensure compliance with public contracting laws from the very beginning of interactions with a public entity.
Persons dealing with the public agency are presumed to know the law with respect to the requirement of competitive bidding and act at their peril. 32/
In denying any recovery to the First Street North developers, the appeals court observed and recommended:
The instant case seems largely the product of size and complexity coupled with the modern phenomenon of “public-private partnerships.” Given the current terms of the charter, it may be that “public-private” projects of this magnitude can only be safely undertaken by a sequence of contracts, with each successive contract protecting a party in plaintiff's position, or by a contract containing conditions subsequent or dispute resolution methods by which undecided issues will later be decided. These approaches might be cumbersome, but the alternative is the course followed here: extensive expenditure before contract resulting in exposure to significant loss in the event of ultimate failure of the contract negotiations. 33/
However, the court’s recommendation for a sequence of contracts could run afoul of the conflict of interest prohibitions of the Political Reform Act of 1974:
No public official at any level of state or local government shall make, participate in making or in any way attempt to use his official position to influence a governmental decision in which he knows or has reason to know he has a financial interest. 34/
“Public official” includes every member, officer, or consultant of a state or local governmental agency. 35/ Thus, a private entity’s participation in one of the early planning contracts could bar it from participation in subsequent design, construction or operation contracts.
There is a carve-out for registered engineers and land surveyors that may prevent an actionable conflict of interest. 36/
| 2.
| Changes in Use (Demand, Revenue) During Operations Phase
|
The revenue generated by infrastructure projects can vary from projections. Often the public agency wants to shift this risk to the private entity. To mitigate this risk, PPP agreements may include non-compete clauses.
Another way this risk is mitigated (from the private entity’s viewpoint) is for the public entity to either guarantee minimum ridership or pay the private entity for availability regardless of use.
Conclusion
PPPs have the potential to bring infrastructure projects forward in time, but there is no free money. The cost of designing, constructing, operating and maintaining infrastructure projects eventually must be borne by the users or a public entity, and the total cost, even when adjusted to net present value, may well exceed the total cost of conventional government debt financing.
If you would like to receive legal reports and updates more quickly, by e-mail, click here and fill out the mailing list form.
For more information about the issues covered in this report, please contact W. Samuel Niece in our San Francisco office at 415-369-7698 or at wsniece@thelen.com or contact your Thelen attorney. For more information about Thelen’s Construction and Government Contracts Department, click here.
ENDNOTES
1/
| See, e.g., Stuart Murray, Value for Money? Cautionary Lessons about P3s from British Columbia, Canadian Centre for Policy Alternatives, p. 13 (June 2006).
|
2/
| American Institute of Architects and Associated General Contractors of America (2004), Primer on Project Delivery, p.4, at www.aia.org/static/
state_local_resources/projectdelivery/
Project%20%20Delivery%20Primer.pdf.
|
3/
| Alameda, Butte, Contra Costa, Del Norte, El Dorado, Fresno, Humboldt, Kings, Los Angeles, Madera, Mariposa, Mendocino, Merced, Monterey, Napa, Orange, Placer, Sacramento, San Diego, Jan Joaquin, San Luis Obispo, Santa Clara, Shasta, Siskiyou, Solano, Sonoma, Stanislaus, Tulare, Yolo and Yuba counties.
|
4/
| Vallejo, Fairfield, Vacaville, Benicia, Suisun City, Dixon, Davis, West Sacramento, Winters, Woodland.
|
5/
| Professional Engineers in California Government v. Department of Transportation, 13 Cal.App.4th 585 (1993).
|
6/
| Statutes 2002, Chapter 688 (AB 1010).
|
7/
| Statutes 2006, Chapter 32 (AB 1467).
|
8/
| Statutes 2006, Chapter 542 (AB 521).
|
9/
| Murray, supra, p. 16.
|
10/
| January 19, 2008, press release from the Office of the Governor.
|
11/
| Professional Engineers in California Government v. Department of Transportation, 13 Cal.App.4th 585 (1993).
|
12/
| Graydon v. Pasadena Redevelopment Agency, 104 Cal.App.3d 631 (1980).
|
13/
| Concerned Citizens Coalition of Stockton v. City of Stockton, 128 Cal.App.4th 70 (2005).
|
14/
| Zottman v. San Francisco, 20 Cal. 96 (1862).
|
15/
| Miller v. McKinnon, 20 Cal.2d 83 (1942).
|
16/
| Walters v. County of Plumas, 61 Cal.App.3d 460 (1976).
|
17/
| Murray, supra, p. 19, quoting HM Treasury, Value for Money Assessment Guide, p.30 (August 2004).
|
18/
| Golden State Transit Corp. v. City of Los Angeles, 493 U.S. 103 (1989); Lusardi Construction Co. v. Aubry, 1 Cal.4th 976 (1992).
|
19/
| Associated Builders and Contractors v. San Francisco Airports Commission, 21 Cal.4th 352 (1999).
|
20/
| Murray, supra, p. 18.
|
21/
| Standard & Poor’s, Accounting for Innovation: Treatment of Off-Balance-Sheet Public Sector Financing Operations, p. 11 (September 23, 2002).
|
22/
| 26 USC §103(a) [“gross income does not include interest on any State or local bond”]; California Constitution, Article 13, §26(b) [“Interest on bonds issued by the State or a local government in the State is exempt from taxes on income”]; 42 Ops.Cal.Atty.Gen. 133 [“since the notes are obligations of the State of California, interest thereon would be exempt from the State of California personal income taxes (Const., Art. XIII, §1 3/4) and federal income taxes (26 USC §103, Reg. §1.103-1) under existing laws, regulations and court decisions”].
|
23/
| See, e.g., Deloitte, Closing the Infrastructure Gap: The Role of Public-Private Partnerships, p. 8 (2005).
|
24/
| IRS Revenue Ruling 63-20.
|
25/
| Department of Transportation, Federal Highway Administration, Key Elements of Public Private Partnership (“PPP”) Agreements, Nos. 4 and 9.
|
26/
| Murray, supra, p. 24.
|
27/
| Murray, supra, p. 23.
|
28/
| Department of Transportation, Federal Highway Administration, Key Elements of Public Private Partnership (“PPP”) Agreements, No. 22.
|
29/
| Murray, supra, p. 42.
|
30/
| Murray, supra, pp. 5, 36.
|
31/
| First Street Plaza Partners v. City of Los Angeles, 65 Cal.App.4th 650 (1998).
|
32/
| Miller v. McKinnon, 20 Cal.2d 83 (1942), but see Marshall v. Pasadena Unified School District, 119 Cal.App.4th 1241 (2004) [construction company was in no position to know the award of the contract was in contravention of the Public Contract Code, and company was entitled to rely on the acts by public officials in awarding company the contract].
|
33/
| First Street Plaza Partners, supra, 65 Cal.App.4th at 671-72.
|
34/
| California Government Code §87100.
|
35/
| California Government Code §82048.
|
36/
| California Government Code §87100.1.
|
©2008 Thelen LLP
|
|
|
