Major Legal Issues for Highway Public-Private Partnerships (2009)

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4 Common legal issues are associated with the imple- mentation of public–private highways. As of July 2008, 23 states have legislation authorizing PPPs. Many states do not have legislation authorizing the use of nontraditional project delivery methods for highway projects. Although the use of toll and other pricing revenues is a common way to finance private participa- tion in highway projects, there remain significant re- strictions under federal and state law on the ability to implement such direct user fees in particular circum- stances. Other potential legal issues arise out of limita- tions on public and private financing methods, envi- ronmental review requirements, labor and employment laws, and public procurement standards. Project risks must also be allocated between the public and private sectors in the PPP agreement. This introduction provides a broad overview of com- mon legal issues associated with implementing highway PPPs and possible solutions implemented to comply with those legal requirements in other U.S. highway PPP projects. Section II examines in detail the different types of PPPs that can be implemented in the highway sector, and Section III presents an overview of repre- sentative projects. Section IV reviews the existing lit- erature on highway PPPs. Section V provides a detailed analysis of the major legal issues associated with high- way PPPs, and Sections VI and VII focus on lessons learned and conclusions from this research. II. DIFFERENT TYPES OF HIGHWAY PPP PROJECT DELIVERY STRUCTURES A. Brownfield and Greenfield Projects3 There are different types of highway infrastructure projects that may be suitable for PPP project delivery structures. The most significant difference is between new and existing highway projects. The operation and maintenance of an existing highway asset typically is referred to as a “brownfield” project. The development and construction of a new highway asset typically is referred to as a “greenfield” project. As a general mat- ter, a greenfield project often will be more complex and expensive than a brownfield project because of the need to plan, finance, design, and construct new infrastruc- ture. Both types of projects can be handled through some form of a PPP. However, the available PPP project delivery structures will vary in the first instance de- pending on whether the undertaking is a brownfield and greenfield project. For a pure brownfield project involving the opera- tion, maintenance, and preservation of an existing 3 See brownfield/greenfield highway projects defined during the testimony of Linda E. Carlisle, Esquire, White & Case LLP, at a hearing of the congressional Subcommittee on En- ergy, Natural Resources, and Infrastructure of the Committee on Finance on “Tax Aspects of Highway Public-Private Part- nerships,” July 24, 2008, available at http://finance.senate.gov/hearings/testimony/2008test/072408lc test.pdf. highway asset, the available PPP project structures generally are limited to long-term operation and main- tenance contracts or long-term lease concessions. These two structures are on opposite ends of the spectrum with respect to the level of private-sector assumption of financial and other risk. A long-term operation and maintenance contract essentially involves the outsourc- ing of these functions to a private contractor. A long- term lease concession, however, often involves the transfer of operating, pricing, and many other tradi- tionally public functions to the private sector. For greenfield projects, a number of different PPP structures will be available depending on which phases of project development (e.g., planning, finance, design, construction, operation, and maintenance) are included within the scope of the project. On one end of the spec- trum, a greenfield project could involve a D/B contract with a private entity for the development phase of the project and public-sector retention of operation and maintenance responsibility once construction is com- pleted. On the other end of the spectrum, a private en- tity could be given the right to design, build, operate, maintain, and finance the development, construction, operation, and maintenance of a new highway under an exclusive franchise and at its own financial risk. The following two subsections describe many of the PPP project delivery structures available for brownfield and greenfield projects. B. Innovative Contracting Techniques The PPP structures discussed in this report can be divided for analytical purposes into two general types: 1) innovative contracting techniques that involve non- traditional forms of project delivery; and 2) innovative financing techniques that involve some form of private debt or equity investment in the project. The primary types of innovative contracting techniques are D/B, DBOM, cost-plus-time bidding (also referred to as “A+B Contracting), construction manager/general contractor (CM/GC), and construction manager at risk (CM at Risk). Since the 1950s, most public highway improvements projects in the United States have been procured on a design-bid-build basis. Under this conventional ap- proach, the state or local highway authority is respon- sible for developing design plans for the project (through its in-house engineering staff or outside con- tractors). Based on those design plans, the public au- thority then solicits competitive bids from private con- tractors for the construction work. The construction work typically is awarded on a low-bid basis, and the project is financed with federal, state, or local funds. Upon completion of construction, the public authority performs an inspection to ensure that the facility has been constructed in compliance with the design plans and then operates and maintains the facility for its use- ful life. Under this traditional procurement methodol- ogy, the public-sector sponsor retains the design risk, the design and construction work is procured sequen-

5 tially, and the public sector retains responsibility for operating and maintaining the infrastructure. The potential advantages of this conventional pro- curement approach are numerous. First, the public au- thority has complete control over the design of the highway improvement. Second, the low-bid procure- ment process is designed to produce the lowest overall project cost. Third, the process is designed to ensure competition among private contractors, promote local public policy objectives (such as ensuring that smaller local contractors have equal access to such construction opportunities), and facilitate transparency in the pro- curement process. Fourth, the institutional framework for highway construction has been established around this traditional procurement methodology. In other words, state and local highway agencies are structured and staffed to procure highway projects in this tradi- tional fashion. The conventional method of procurement, however, can have a number of potential disadvantages, particu- larly with respect to large and complex projects. First, the public sector is subject to significant financial expo- sure from change orders and delay claims. These claims can have an enormous adverse impact on project sched- ule and total project cost. Such claims typically arise because of unanticipated design flaws or site conditions that the construction contractor uses as a basis for seeking additional funds above the original bid price. Second, the conventional method relies on complete public financing of the project. Third, it does not take advantage of potential synergies between the design and construction phases of the project because these phases are performed sequentially and often by differ- ent entities. There is no “single point of contact” that will be responsible for both design and build risks. Fourth, the traditional method does not reward exper- tise, quality, and innovation in the evaluation of bids. These contracting methods all involve greater roles for the private sector than under the traditional design– bid–build method of highway construction contracting. It is estimated that innovative contracting methods can achieve costs savings of up to 20 percent compared to conventional procurement. 1. Design–Build Under D/B contracting,4 the design and construction procurements are combined into one fixed-fee contract with a “single point of contact” that is responsible for both design and construction. The D/B contractor (which may be one company or a consortium of design, construction, and project management firms) assumes the “design risk” that detailed design drawings and specifications will be free from error and agrees to con- struct the project in accordance with its design. The potential benefits of D/B contracting relative to tradi- tional procurement include time savings, cost savings, risk sharing, and quality improvement arising from the synergies created by having one contractor responsible 4 See 23 C.F.R. 636.103. for both functions. The use of D/B performance specifi- cations developed by the public sector, instead of tradi- tional prescriptive specifications, also encourages inno- vation by the private contractor. Some D/B contractors are willing to guarantee that they will meet material, workmanship, and other per- formance guarantees for a specified period of time (typi- cally 5 to 20 years) after the project has been delivered. This type of D/B with warranty approach allocates qual- ity risk to the contractor and reduces the project spon- sor’s need to conduct inspection and testing during pro- ject delivery. A D/B contractor that is willing to provide a warranty for materials or workmanship, or that re- mains contractually obligated for maintenance after construction, is compelled to complete life-cycle-cost analyses of all design and construction options. This provides an additional potential benefit to the public project sponsor by shifting the risk of project quality to the private contractor. 2. Design–Build–Operate–Maintain Under the DBOM5 approach, the private contractor will be responsible for both the design/construction phase and the operation/maintenance phase for a speci- fied period of time under a single contract. The contrac- tor (often a consortium of design, build, operating, and project management companies) agrees to meet various performance standards established by the public spon- sor involving physical condition of the asset, capacity, and congestion management. The potential benefits of the DBOM approach are the increased incentives for the delivery of a higher quality project because the con- tractor is responsible for operating and maintaining the facility for a specified period of time after construction. Thus, it is in the DBOM contractor’s best interest to consider life-cycle costs and provide high-quality con- struction in order to avoid higher life-cycle maintenance and improvement costs during the operating phase. A DBOM contractor effectively assumes the risk that it will comply with the public sponsor’s performance speci- fications, deliver the project on time and on budget, and ensure the quality of construction and the performance of maintenance and rehabilitation throughout the oper- ating phase. 3. A+B Contracting A+B contracting,6 also known as cost-plus-time bid- ding, is a procurement approach that selects the lowest bidder based on consideration of both (A) the proposed price for the contract bid items and (B) the value asso- ciated with the time needed by the contractor to com- plete the project. This procedure is intended to provide a contractual incentive for the A+B contractor to mini- mize delivery time for high priority and congested 5 See Fig. 2.2, Contracting Methods Involving Different Lev- els of Involvement, U.S. DEP’T OF TRANSP., REPORT TO CON- GRESS ON PUBLIC PRIVATE PARTNERSHIPS (2004) (“USDOT Report”), at 13. 6 Id. at 14.

6 highways by offering incentives for early completion and assessing penalties for late completion.7 A+B con- tracting shifts the risk of failing to meet project dead- lines to the private contractor. One related technique that is designed to expedite project completion and minimize road user impacts is the practice of assessing “lane rental” fees against the contractor for every traffic lane that needs to be taken out of service during construction on an existing facil- ity. A lane-rental fee typically is based on the estimated cost of delay or inconvenience to the road user during the rental period, assessed for the period of time that the contractor occupies or obstructs part of the road- way, and deducted from monthly progress payments. 4. Construction Manager/General Contractor Under the CM/GC8 approach, the project sponsor si- multaneously hires both the design contractor and the building contractor. Both contractors work together to develop innovative design and construction solutions that are tailored to the particular project. However, the project owner retains full control of project design throughout the design process. The CM/GC approach is valued for accelerating project delivery for certain types of projects, such as bridge construction.9 5. Construction Manager at Risk The CM at Risk10 project delivery structure involves a separate contract for a construction manager and a design contractor during the initial phase of the project. The construction manager negotiates a D/B contract with the project sponsor during this initial phase as the design work progresses. The potential benefits of this approach include advancement of the project during price negotiations and the potential for more optimal teaming among the members of the private consortium. C. Innovative Financing Techniques In addition to the innovative contracting techniques discussed above, there are a number of project delivery structures that can be used when the private sector intends to provide some debt or equity financing to the 7 A+B contracting is a technique supported by the Federal Highway Administration (FHWA) under its experimental SEP- 14 program, which is discussed in further detail below. 8 See FED. TRANSIT ADMIN., CONSTRUCTION MANAGEMENT AND GENERAL CONTRACTING GUIDELINES, 2003 update, avail- able at http://www.fta.dot.gov/printer_friendly/publications_1363.html. 9 The Utah Department of Transportation (UDOT) is pursu- ing six CM/GC projects at various states of development under the [SEP-14] program and is seeking FHWA approval to allow UDOT to pursue 24 CM/GC federal-aid projects each year for 2 years on a pilot project basis. See Written Testimony of John R. Njord, Executive Director, Utah Department of Transportation, Before the House Subcommittee on Highways and Transit (Apr. 17, 2007) (“Njord Testimony”). 10 See description given by the American Institute of Archi- tects, available at http://www.aia.org/adv_st_constructionmanageratrisk. highway project. These structures are referred to herein as “innovative financing techniques” and discussed in more detail below. There are a number of different pri- vate financing tools that can be used to facilitate pri- vate-sector investment in highway projects. These tools, which include financing under the Transportation In- frastructure Finance and Innovation Act of 1998, 23 U.S.C. § 181-189 (TIFIA), and private activity bonds, also are discussed briefly below and can be used in con- junction with any of the innovative financing tech- niques described herein. 1. Design–Build–Finance–Operate The design-build-finance-operate (DBFO)11approach is a variation on the DBOM structure that involves some level of involvement by the private contractor in financing the design, construction, operation, and maintenance of the highway asset. Typically, the DBFO model uses revenues generated from the operation of the facility (usually in the form of tolls or other pricing mechanisms) to repay the private and other financing used to construct the facility. The potential benefits of the DBFO approach include those benefits available under the DBOM approach plus the transfer of finan- cial risk to the DBFO contractor during the contract period. A variation on the DBOM approach is the build– transfer–operate (BTO) arrangement, under which the contractor retains ownership of the project until con- struction is completed. Under both the DBFO and BTO structures, the public sponsor will own the facility after completion of construction. Only a few toll road projects in the United States have been procured using the DBFO model because public agencies generally are able to obtain cheaper, tax-exempt debt through traditional municipal financ- ing methods. However, in the last several years, more design-build, operate, finance, and maintain/manage (DBFOM) projects are being planned or implemented because of limits on the amount of tax-exempt bonds that can be issued by state entities and due to the emergence of several innovative financing techniques (such as TIFIA financing, private activity bonds, and 63-20 public benefit corporations) that can provide fi- nancing at rates that are almost as low as tax-exempt debt.12 Another DBOM financing option is known as “avail- ability payments”—a type of PPP in which the public entity agrees to make regular payments to the private 11 See U.S. DEP’T OF TRANSP., 2006 STATUS OF THE NATION’S HIGHWAYS, BRIDGES, AND TRANSIT CONDITIONS AND PERFORMANCE, Report to Congress, Jan. 22, 2007, at 357, available at http://www.fhwa.dot.gov/policy/2006cpr/pdfs/cp2006.pdf. 12 See, e.g., Greg Korbel Design, Build, Finance, Operate, and Maintain Project—BART Oakland Airport Connector Pro- ject, Infrastructure Law Blog, posted on Mar. 10, 2006, avail- able at http://www.infrastructureblog.com/2006/03/articles/alternative- project-delivery-m/design-build-finance-operate-and-maintain- project-bart-oakland-airport-connector-project/.

7 party based on the facility's availability and level of service achieved for operations and maintenance. In this case, the public entity normally accepts the reve- nue risk and may provide some level of initial funding to offset capital requirements. The private entity takes the risk of project delivery, maintenance, and opera- tions. This method is currently more prevalent with transit work. Transit agencies are experimenting with adding incentive payments based on increased ridership or service.13 2. Build–Operate–Transfer The build–operate–transfer (BOT)14structure is simi- lar to the DBFO approach except that the contractor retains ownership of the facility after construction and during the operating and maintenance phase of the project. A variation on this is the build–own–operate structure, which does not necessarily involve a contrac- tual obligation to transfer the facility back to the public sector upon expiration of the useful life of the asset. The potential advantage of the BOT and similar structures is that the contractor accepts all revenue risk and re- ward during the operating and maintenance phase of the project. These structures have not been used very often in the U.S. highway sector. Recently BOT strate- gies have been considered for portions of I-69 and the Southern Indiana Toll Road.15 3. Long-Term Lease Concessions Among all the different PPP project delivery struc- tures discussed in this digest, the long-term leases of the Chicago Skyway and Indiana Toll Road have re- ceived the most attention from the general public. Often criticized as the “privatization” of a public asset, the Chicago and Indiana deals involved the long-term lease of an existing road to a private concessionaire for a specified period of time.16 Under such a lease arrange- ment, the concessionaire agrees to pay an up-front, lump-sum fee17 to the public agency in exchange for the right to collect revenues generated by the facility over 13 Philip Armstrong and Mel Placilla, Public-Private Part- nerships: What’s Old Is New Again, CE news.com, Jan. 29, 2008, available at http://www.cenews.com/article.asp?id=2632. See also transcript of June 14, 2007, meeting of Texas Depart- ment of Transportation Commission, during which the concept of availability payments is fully discussed, available at http://www.txdot.gov/about_us/texas_transportation_commissio n/07_jun14_transcript.htm. 14 See U.S. DEP’T OF TRANSP., supra note 11. 15 See discussion of BOT use associated with Indiana portion of I-69 found in Nationmaster.com (information about new or planned highways), available at http://www.nationmaster.com/encyclopedia/Interstate-69.0. 16 See Susan Chandler, You Pay a Lot More: What Happens When the City Leases Public Assets to Private Investors, CHICAGO TRIBUNE, Sept. 7, 2008, available at http://www.chicagotribune.com/business/chi-sun- infrastructure-sale-chicsep07,0,6786305.story. 17 Compensation could also be in the form of revenue shar- ing. the life of the contract (typically 25 to 99 years). The concessionaire agrees to operate and maintain the facil- ity during the term of the lease and may also agree to implement technological innovations (such as electronic tolling) or other capital improvements to the facility. The potential benefits of a long-term lease include the public agency’s ability to obtain a significant up-front payment; the transfer of the political risk of increasing user fees to the private sector; the allocation of most project, financial, operational, and other risks to the private concessionaire; and the ability to implement private-sector efficiencies and technology in operations and maintenance for the benefit of the road users. Many of these potential benefits are also the aspects of such arrangements that have been criticized for failing to protect the public interest, as discussed elsewhere in this report. 4. Innovative Financing Tools There are a number of innovative financing tools available to private-sector entities that are willing to provide debt or equity financing for highway projects. In addition to standard financing mechanisms available in the general capital markets, including lines of credit, loan guarantees, and other debt instruments, private- sector entities have the ability to use TIFIA financing, private activity bonds, or funding from state infrastruc- ture banks on highway projects. These tools are briefly summarized below.18 These tools often must be used in conjunction with tolling and pricing strategies that gen- erate sufficient revenues to reduce debt or finance op- erations. a) TIFIA Financing.—TIFIA19 allows USDOT to pro- vide direct credit assistance to the sponsors of major transportation projects. The TIFIA program tools are designed to occupy the area between 1) traditional grant projects that do not generate revenue from tolls or other revenue sources and 2) projects that generate sufficient revenue to support marketable securities without governmental credit assistance. The TIFIA program offers three distinct types of financial assis- tance—direct loans, loan guarantees, and standby let- ters of credit. The project sponsors eligible for TIFIA assistance may be public or private entities. There are various criteria that must met to qualify for TIFIA as- sistance, and only 33 percent of eligible project costs can be supported. 18 The various tools available to finance highway projects are not the central focus of this report. For more detailed in- formation on this subject, see CONGRESSIONAL BUDGET OFFICE, INNOVATIVE FINANCING OF HIGHWAYS: AN ANALYSIS OF PROPOSALS (1998); FED. HIGHWAY ADMIN., MANUAL FOR USING PUBLIC-PRIVATE PARTNERSHIPS ON HIGHWAY PROJECTS (2005); TRANSP. RESEARCH BD., Special Report 285, THE FUEL TAX AND ALTERNATIVES FOR TRANSPORTATION FUNDING (2006); NAT’L COOP. HIGHWAY RESEARCH PROGRAM, Project 20-24(49), FUTURE FINANCING OPTIONS TO MEET HIGHWAY AND TRANSIT NEEDS (2006). 19 23 U.S.C. § 601–609.

8 b) Private Activity Bonds.20—A private activity bond is a form of tax-exempt bond financing that can be is- sued by or on behalf of state or local governments to provide special financing benefits for qualified projects. Under current law, highway and other transportation facilities are eligible for up to $15 billion in tax-exempt private activity bonds that are not subject to the gen- eral annual volume cap on private activity bonds for state agencies and other issuers. The primary advan- tage of a private activity bond is that it attracts private investment for projects having some public benefit and reduces financing costs to levels that are close to tax- exempt municipal financing rates. c) State Infrastructure Bank Credit Assistance.21— State infrastructure banks (SIBs) are revolving funds administered by states that support surface transporta- tion projects. SIBs offer low-interest loans, loan guaran- tees, and other credit enhancements to public and pri- vate sponsors of federal-aid highway projects. The Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users (SAFETEA-LU) established a new SIB program that allows all states to enter into cooperative agreements with the Federal Highway Ad- ministration (FHWA) to establish infrastructure revolv- ing funds eligible to be capitalized with federal trans- portation funds authorized for fiscal years 2005–2009.22 This program gives the states the capacity to increase the efficiency of their transportation investments and significantly leverage federal resources by attracting nonfederal public and private investment. d) 63-20 Public Benefit Corporations.—A 63-20 cor- poration is a nonprofit corporation that, pursuant to Internal Revenue Service Rule 63-20 and Revenue Proc- lamation 82-26, is authorized to issue tax-exempt debt on behalf of private project developers. In order to qual- ify for this status, the nonprofit corporation must en- gage in activities that are “public in nature,” the state (or a political subdivision thereof) must have a “benefi- cial interest” in the corporation while indebtedness re- mains outstanding, and unencumbered legal title in the financed facilities must vest in the government until after the bonds are paid. State and local governments can issue tax-exempt toll revenue bonds through established conduit issuers or by creating 63-20 nonprofit corporations. Although the conduit method is preferred, the 63-20 method pro- vides a viable alternative that can be used to finance revenue-generating highway projects in two different ways. First, a 63-20 corporation can issue debt by lever- aging future expected toll revenues and can enter into a 20 See U.S. DEP’T OF TRANSP., INNOVATION WAVE: AN UPDATE ON THE BURGEONING PRIVATE SECTOR ROLE IN U.S. HIGHWAY AND TRANSIT INFRASTRUCTURE (2008), available at http://www.fhwa.dot.gov/reports/pppwave/ppp_innovation_wav e.pdf. 21 See 23 U.S.C. 610, SAFETEA-LU, § 1602, program dis- cussion available at http://www.fhwa.dot.gov/safetealu/factsheets/sibs.htm. 22 23 U.S.C. 610, § 1602 (2008). DBOM agreement with a private contractor to design, build, operate, and maintain the facility for a specified period. Alternatively, the public sponsor of the project could agree to lease the toll highway to be developed by the 63-20 corporation to a private entity, and the 63-20 corporation would leverage the future lease payments to issue its debt. Under both of these arrangements, the private partner may assume responsibility for arrang- ing the financing, but the debt would be issued on be- half of the 63-20 corporation.23 e) Tolling and Variable Pricing Initiatives.—There are a variety of strategies available to impose direct fees on the users of highway facilities. The most com- mon is a toll that can be imposed on a flat-fee basis. An alternative approach is some form of variable or conges- tion pricing, which charges higher user fees based on the level of traffic volume or time of day (e.g., peak-hour premium). There are a number of different technologies that can be used to collect such tolls, including elec- tronic toll collection systems, automatic vehicle identifi- cation systems, and video-based toll collection enforce- ment. As noted above, there is a common perception that federal and state gas taxes and other traditional meth- ods of infrastructure finance alone cannot provide ade- quate funds for the enormous capital and maintenance requirements of the highway network. Tolling is an alternative strategy that can provide positive cash flow to invest in new capacity or reinvest in existing sys- tems. Variable or congestion pricing is a mechanism that can increase the capacity of new or existing high- way assets by spreading out demand and reducing con- gestion at peak hours. It has been supported by a wide spectrum of stakeholders, including economists (who view congestion pricing as the most efficient method of allocating constrained resources) and certain segments of the environmental community.24 The use of tolling or pricing techniques does not have to be implemented as part of a PPP. There are many toll roads operated by state and regional turnpike au- thorities. In addition, not all PPPs in the highway sec- tor (as defined in this report) involve tolling or pricing techniques. The use of innovative contracting methods such as D/B does not require any implementation of user fees. Nonetheless, the use of tolling and pricing expands the type and potential benefits of PPPs that can be implemented in the highway sector, particularly as a means of encouraging private-sector investment in highway facilities. PPP project delivery structures in- volving tolling and pricing include both long-term con- cessions for the design, build, finance, and operation 23 See FHWA Overview of Non-Profit Public Benefit Corpo- ration Models, available at http://www.fhwa.dot.gov/PPP/dbfo_6320.htm. 24 For more background on the potential benefits of variable tolling and congestion pricing, see Environmental Defense, No More Just Throwing Money Out the Window: Using Road Tolls to Cut Congestion, Protect the Environment, and Boost Access for All (2006), available at http://www.edf.org/documents/5257_TollingReport0506.pdf.