US P3s are very much like their PFI antecedents. The government grants a concession to construct and operate a specified infrastructure asset such as a toll road and the concessionaire implements the plan. The public gets the asset without public debt, and sometimes without the burdensome public construction requirements that can slow the progress of large projects.

The concessions come with operating standards, toll or rate limits, often a base rate plus an inflationary index, emergency step-in rights and often default termination penalties. While the private debt raised in these projects is not tax-exempt, as would be the case with direct municipal debt, the loss of this indirect federal subsidy is offset by the federal tax benefits the equity owners can enjoy by virtue of their tax ownership of the asset. Several opportunities to combine P3s with tax-exempt debt remain, and there is a growing focus on tax-exempt debt structures as the means of reducing the cost of funds as the US market begins to mature.

Federalism and focus

By contrast to PPP projects elsewhere in the world, which are based upon national legal systems, state law heavily governs US P3 transactions. Federal tax laws are a significant structuring factor – including those that govern tax-exempt debt, the federal securities laws may apply to disclosure, federal bankruptcy laws often control default outcomes, and federal permitting and national security requirements may apply to certain assets. But the core issue is authorisation or, as the British call it, "vires". Very different rules apply, from state to state, to the nature and extent of state and local government power and care must be taken to be sure that these transaction are not ultra vires.

The only specific principle of public law that is likely to apply is Dillon's Rule, which states that a local government has only the powers specifically granted to it, and those necessary or essential to achieve its corporate purposes. This may come as something of a surprise to those in corporate law, where business corporations are generally empowered to take such acts as are desirable or convenient to accomplish their business purposes, a materially broader standard.

States, by contrast, have sovereign power, and with it the power, and often the inclination, to legislate about their major initiatives, assuming rights and powers constrained only by their respective individual constitutions (and the US Constitution), also something not encountered in the corporate world. In the realm of property and affairs of government (PAG), federalism is alive and well.

Another surprising feature of municipal law is the concept of home rule. Some states are home rule states, in which the power of local government is controlled by local legislation. Most states, however, generally follow the political subdivision model in which the local governments retain their separate corporate entity status but exist as subdivisions of the sovereign, their activities closely circumscribed by the mandates of Dillon's Rule. Nevertheless, even in these jurisdictions, there are limited constitutional home rule provisions allowing local governments certain autonomous powers within the PAG framework. An analysis of the authority of a local government to undertake all but the most ministerial act will likely involve a review of the state constitutional issues implicated in such action.

More generally, from state to state, principles of sovereignty may limit both state and local authority to contract away the power to provide core government services. This concern – the potential inability to agree not to compete – is comparable to the issue of the enforceability of a non-substitution provision in a tax-exempt (or taxable) government lease financing. Certainly, the continuing basic sovereign power of eminent domain hangs over all concession transactions, however structured.

New York's public finance tension

The early 19th Century was the beginning of the era of railroad bonds: public debt to stimulate private economic activity, another version of public private partnership. New York State's first big version was called State Stock, issued in 1836. It was secured by a mortgage on the railroad bed and it was in default five years later, with the holders getting 5 cents on the dollar. These early schemes led to judicial and constitutional limitation on state borrowing.

To circumvent reform attempts to limit state railroad debt, the State Legislature authorised local governments to issue bonds to purchase railroad stock. There followed several rounds of constitutional amendments, which imposed limits upon local governments, and most of which remain today, including prohibitions on gifts or loans of money or credit. These prohibitions, which can also be found in other states, must be critically analyzed when structuring P3 transactions and, specifically, termination payments.

In 1915, the State Legislature engineered an end run around the constitutional limits on its own borrowing power. It created the Hudson River-Black River Regulating District with power to incur debt. The legislation stated that the bonds would not be debts of New York State. The courts approved the plan and upheld the power of this new entity to issue debt outside of the limitations of the state constitution.

By the 1930s, New York State authorities based upon this legal theory were pervasive. Every bridge, road and tunnel was owned and financed by a public authority. With each authority came a bureaucracy, outside statutory limitations on state operations, becoming, in effect, a shadow government.

The 1938 Constitutional convention produced a new constitution that required a special act of the legislature to create an authority and stated the state shall not be liable on the debt of these entities. This provision, intended as a limitation, instead served as a blessing of this new form of off-balance sheet state debt. Such transactions were legal since they were not debts of the state, thus setting the stage for many modern New York public finance strategies.

The New York courts followed this reasoning and did not look to economic substance arguments that off-balance sheet financing constitutes debt of the state or its local governments. This legal approach, maintained through subsequent challenges in the Wein and Schulz cases, would be followed by New York courts were a challenge to the made to a P3 transaction asserting that the leveraging of a public asset constitutes an unconstitutional state or local debt.

Nevertheless, in structuring P3 agreements, participants must be cautious about any required municipal payment, since these basic principles also mean that the actual outlay may be subject to appropriation or, in fact, unconstitutional debt or an unconstitutional extension of credit. Structuring these obligations as services agreement may mitigate this risk.

In 2006, for instance, a bill was introduced in the New York State Legislature that would have specifically authorised the New York State Department of Transportation, the Thruway Authority and the Metropolitan Transportation Authority to enter into certain transportation development partnerships with public and/or private entities. The bill would have given DOT, Thruway and MTA the authority to enter into many relationships for the delivery of transportation projects, facilities and services.

Under the bill, which did not go forward, public or private entities could acquire, design, finance, construct, improve, operate and maintain transportation facilities, provide transportation services, and impose user fees for the use of the facilities or services. The imposition of any fares, tolls or other charges, however, would be limited to transportation facilities that currently impose user fees, are newly constructed, or increase capacity.

The introduction of the legislation does not affect the current powers of the state or its authorities to engage in transactions otherwise permitted by the State Constitution, and statutes authorizing state departmental action or the enabling legislation of state public benefit corporations nor does it limit the power of local governments to take action permitted by general statutes or local laws adopted pursuant to home rule legislation.

Texas and its special circumstances

The early history of Texas, played out under the flags of France, Spain, Mexico, the Republic of Texas, the Confederacy, and the United States of America. Texas local governments were insignificant under French, Spanish, and Mexican rule. The Republic of Texas, beginning in 1836, used the Spanish and Mexican model of special charters for municipalities, as did the state when it entered the Union as a sovereign.

This history accounts for the main theory of Texas state constitutional law: powers not prohibited exist in the state and therefore, many restrictions on the power of the state to act are necessary. This is responsible for the length of the Texas constitution, and its many restrictions on state and local government.

In 1912, Texas enacted the Home Rule Amendment to the Constitution. The state completed the shift from the Spanish model of specially chartered cities to the authorisation of home rule, empowering local communities and local legislative bodies to legislate within the local sphere. While a series of holdings by the highest Texas courts has limited many of the possible effects of the amendment, it remains an important source of potential, if largely unused, power.

Health care and transportation illustrate the mix of state and local government authority for public-private partnerships and concessions. By contrast, significant P3 transportation projects in Texas generally are administered and controlled at the state level and are based on special purpose legislation of recent vintage. One might trace the beginnings of the Texas Transportation Commission's P3 activities to the adoption in the late 1980s of a cost-per-vehicular-mile method of prioritizing certain projects. Never slow to miss opportunities, real estate developers not only helped sharpen the pencils of the traffic consultants, but also undertook to contribute right-of-way, environmental mitigation land and engineering costs to drive down the cost-per-vehicular mile to promote early project development and bring certainty to the developer's land planning.

Since then, the Commission has come a long way and, although there have been some innovative developments in legislative authority for local communities, the P3 story in Texas transportation has been written primarily at the state level. In particular, during the 2003 and 2005 legislative sessions, the legislature, the Commission and industry participants worked to create, overhaul and fine-tune legislation allowing long term concessions, now codified throughout Title 6 (Chapters 201 through 472) of the Texas Transportation Code.

At both the local and the state levels, however, constitutional principles set the parameters for risk allocation. Generally, a private party cannot look to the government for guarantees of the private party's debt. Not only does this have implications for lease or concession terminations, but also the government typically cannot be a true joint venture partner, as it cannot be exposed to the liabilities generated by the private participant. Future funding commitments, including pass-through toll commitments and the commitment to pay for indigent health care, are subject to appropriation and, therefore, potentially at risk.

A government cannot agree to delegate to the private sector a core government decision-making function. Consequently, in both the health care and transportation examples, it is not feasible to seek (or in any event to rely on) a covenant limiting the government's ability to compete. The government choosing to compete could, however, be a permissible basis for termination. While anathema in the transportation industry which is focused on the long-term upside potential, such termination provisions are relied on in the health care sector as an effective deterrent because of the cost impact to the government of having to fund the indigent care burden.

But perhaps the most unusual challenge to the private sector in dealing with Texas governments is the existence of sovereign immunity, specifically immunity from suit for monetary damages, which is enjoyed by the state, counties and other local government entities, including now home rule cities. Except to the extent immunity is expressly waived by the legislature, it is not possible to sue one of those entities for monetary damages, even in the context of seeking payment for work performed under a contract.

Chapter 271 of the Texas Local Government Code provides a mechanism for resolving claims for payment under written contracts for goods and services. In addition, Chapter 223 of the Transportation Code provides a judicial mechanism to enforce termination obligations of the Commission in the event a private interest in a concession is terminated.

Yet just last summer, the Texas Supreme Court extended general sovereign immunity protection even to entities that had been authorised under legislation to sue and be sued (or plead and be impleaded), including certain home-rule municipalities. Also of interest, if a claimant recovers against the government entity and the payment of the damages has not already been appropriated or is not otherwise lawfully available, the claimant will need to seek discretionary approval of the governmental entity to appropriate funds to make the payment. The legislature will meet from January through at least May, and it remains to be seen if P3 pressures will contribute to changes in this unusual situation.

West coast willing?

California's 1879 Constitution contained limitations on the authority that may be granted to local governments in the area of public debt and financial transactions, and also reserved to the people the power to enact statutes and amend the Constitution by initiative and the power to repeal legislative acts by referendum. Courts have held these powers are available to the electorate of local agencies as well as the state as a whole. Initiatives can impose limitations in California on the power of a locality to enter into certain types of transactions, such as voter approval requirements or limits on the use of proceeds.

Since 1978, California voters have approved four state initiative measures, all but one of them constitutional amendments, which have limited local fiscal flexibility and have been the catalyst for the creation of many financing techniques used today in the state.

This history has pushed California local governments to alternative financing mechanism such as COPs (lease certificates) and CFDs (Community Facilities Districts) and could help drive P3 activity in the State. In 1985, California enacted the Local Government Privatization Act of 1985 which authorised a "local agency" to authorise, grant or enter into one or more exclusive or non exclusive franchise, license or service agreements with a privatizer for the design, ownership, financing, construction, maintenance or operation of a privatization project, and to enact any measures necessary and convenient to carry out the powers granted by the 1985 act.

A "privatization project" was defined in the 1985 act to mean any wastewater or sewerage project that is owned and operated by a corporation, partnership, or natural person under a franchise, license or service agreement with a local agency or any agency of that local agency, under which services are supplied for the benefit of the local agency, its residents, or both, or any agency of the State.

In addition, the 1985 act defined "project" to include, but not be limited to, financing, designing, constructing, repairing, replacing, maintaining, and operating collector systems, pumping stations, treatment plants, and lateral interceptors, and outfall sewer, and defined "privatizer" to mean any corporation, partnership, or mutual person, excluding municipal corporations, which owns and operates a wastewater or sewerage project pursuant to a franchise, license or service agreement with a local agency.

In 1989, California enacted Assembly Bill 1010, which authorised the State Department of Transportation to test the feasibility of building privately-funded transportation facilities by developing four demonstration projects to solve state transportation needs that could not be met with available public revenue. The authority granted under this legislation lapsed on 1 January 2003.

A significantly broader privatization statute was added in 1996, which stated that it was the intent of the legislature that the chapter be construed as creating a new and independent authority for local government agencies to utilize private sector investment capital to study, plan, design, construct, develop, finance, maintain, rebuild, improve, repair, or operate, or any combination thereof, fee – producing infrastructure facilities.

The 1996 act authorised a governmental agency to solicit proposals and enter into agreements with private entities for the design, construction, or reconstruction, and may lease to, private entities for many types of fee-producing infrastructure projects.

In 1996, the legislature also enacted a provision authorizing municipal corporations to lease, sell or transfer, for just compensation, all or any part of a public utility owned and operated for the purpose of furnishing water service. Sale of all or part of a municipal water system requires two-thirds approval by the qualified voters of the municipality.

In 2006, the 1989 Transportation Facilities Bill was amended for the purpose of facilitating public and private transportation projects. The new legislation authorises the California Department of Transportation, and certain regional transportation agencies, to enter into comprehensive development lease agreements with public and private entities, or consortia of those entities, for certain transportation projects that may charge certain of those projects tolls and user fees, subject to various terms and requirements. The projects would be primarily for the improvement of the movement of goods in commerce. The bill would also authorise regional transportation agencies, in cooperation with the California Department of Transportation, to apply to develop and operate high-occupancy toll lanes, including the administration and operation of a value pricing program and exclusive or preferential lane facilities for public transit.

Each US state will approach the implementation of P3s in its own way, whether through the adoption of special or comprehensive state legislation, as has happened in many states, or based upon existing constitutional, statutory and home rule powers. As with any emerging market, certainty about local law will be key to investor confidence.

Participants in this market may do well to follow their nineteenth century counterparts, the early municipal bond market investors, who responded to waves of defaults of railroad bonds, which courts then often found to be illegal, by demanding an opinion of counsel with specific expertise in public affairs as to the proper authorisation of these instruments. This practice, which came to known as the issuance of an approving opinion, may be a useful precedent in the development of the emerging US P3 market.