With this installment, we turn to an article that was first published in the Project Finance Newswire in February 2013 and written by Amanda Rosenberg, an Associate in our Project Finance Group.
Non-appropriation risk in government contracts
Many jurisdictions place restrictions on contracts with government entities that straddle two or more fiscal years. The government must reserve the right in the contract not to make payments if the money for payments is not appropriated by the state legislature, county council or other legislative body. The reservation of rights is called a non-appropriation clause.
Such a clause can affect financeability. However, by taking a few simple steps, a developer can help protect his interests and ensure a successful financing.
Two main issues arise.
First, some jurisdictions prohibit government contracts that extend beyond the current fiscal year unless the contract obligations are covered by long-term bond authority. Often, there are exceptions for leases, power contracts and energy savings contracts that permit such contracts to run beyond the fiscal year. However, the permitted term still may be shorter than the parties want (for example, five or 10 years).
Second, in some cases, a contract may extend beyond the statutory limit if the contact has a non-appropriation clause allowing the government to get out of the contract or certain of its payment obligations if a future legislature fails to appropriate funds for the contract. One legislative body cannot bind a future legislature to spending.
Debt limitsMany state constitutions and statutes restrict the ability of a state or local government to enter into a contractual obligation that is considered debt. Governments are usually limited in the amount of debt they can issue, and municipalities often require voter approval in order to issue debt.
The rules differ among jurisdictions. Some may restrict multi-year appropriations for leases but allow governments to guarantee funding for long-term power contracts or energy savings contracts (such as for LED lighting). Others permit leases, but not the other forms of agreements.
As an example, in New York, a municipal contract generally may not extend beyond one year unless it includes a non-appropriation clause. However, second class cities in New York may enter into lighting contracts for up to five years without having to include the clause.
It is not always possible to structure a deal to fit the type of long-term contract that is permitted.
If an obligation is determined to be debt and its issuance did not comply with state borrowing rules, then the counterparty runs the risk of non-payment or having to repay rent or other amounts previously paid to it by the municipality.
In an age of budget deficits and fiscal cliffs, governments can easily become overextended. They need access to utility services and equipment, but may have strained finances.
The power contract or lease is an effort to avoid running afoul of debt issuance laws. Rather than own a project itself and borrow money to build it, the government signs a long-term contract to buy electricity from a project built and owned by someone else. One form power contract with a federal agency requires the agency to terminate the agreement and pay a termination fee if sufficient funds are not appropriated to cover the government's obligations. Other contracts may simply require the contract to terminate without penalty.
How does the developer best protect its interests? What duties can it impose on the government entity to limit the risk of non-appropriation? If the government fails to appropriate funds, what protections does the counterparty have with respect to the property leased or provided?
Several safeguards can be included in contracts with government entities.
One common safeguard is a non-substitution clause. The government entity agrees not to sign a similar contract with a different counterparty for the same services or equipment if the agreement is terminated, at least for a specified period of time. The term of the clause varies from agreement to agreement but usually ranges from a few months to a year.
A non-substitution clause protects against a failure to appropriate funds to meet payment obligations under an existing contract simply because a better deal came along.
Although non-substitution clauses are generally standard provisions in government contracts, they are limited in scope and such a clause applies only to the extent permitted by law. There may be an issue as to enforceability because such a clause makes it harder to exercise rights under a non-appropriation clause, thereby calling into question whether the non-appropriation clause is effective to salvage the contract. Consideration should be given to enforceability in the relevant jurisdiction. The parties often include a non-substitution clause anyway, even if it is not enforceable, as a sign of good faith that the government intends to honor the contract for the full term.
The contract should require the government entity to covenant that it will take all steps necessary to seek appropriations, to the extent permitted by law, each year. Such contracts often require the entity to submit budget requests each year that are sufficient to cover the government entity's payment obligations for the following fiscal year.
Another protection is a statement or letter of essential purpose. This is a letter acknowledging that the government entity needs the service or equipment for an essential purpose: for example, electricity to keep schools open or fire trucks or police cars to fight fires and protect the public.
Developers should consider the purpose for which the services or equipment will be used. Consider two power contracts. If a developer is providing electricity to a municipality to power a city hospital, then whether the services are essential is obvious. However, if the electricity will be supplied to a satellite office housing minimal staff, the government has less invested in the contract and may be more likely to let the contract lapse if it is forced to reduce its budget.
In an equipment lease, the lessor not only retains ownership of the assets but also takes a security interest in them to secure payment of rent and other obligations. This is another protection in cases where the lease is cut short due to non-appropriation of funds. The project owner will need access to the site to reclaim its property.
An obvious question is how much of a risk non-appropriation poses to a developer trying to finance a project. There is little good data on how often non-appropriation clauses have been invoked in practice. The Equipment Leasing & Finance Foundation is doing a survey. It hopes to have results by April. At the end of the day, most tax equity investors and lenders appear to take comfort in power projects that utility bills are usually among the last bills that struggling customers stop paying. Electricity is essential.