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"The Use of '63-20' Nonprofit Corporations in Infrastructure Facility Development"

Nossaman Infrastructure
05/01/01

I. Advantages of Nonprofit Corporations in Development of Infrastructure Facilities

The use of nonprofit corporations (sometimes referred to as "63-20 Corporations") in structuring public/private infrastructure financings has recently attracted a great deal of attention. Its use is being promoted as a way to preserve the ability for a project to be financed with tax-exempt bonds, while maintaining for both the public and private participants most of the benefits of private development.

Nonprofit corporations have long been used as a vehicle to finance the construction of public buildings, including hospitals, court houses and schools. Historically, such projects have been accomplished through the use of nonprofit corporations in order to avoid statutory debt limitations and other restrictions. More recently, private developers in association with public agencies around the country have begun to utilize the nonprofit structure to develop major transportation projects, particularly those involving innovative contracting and public-private partnerships. Examples include Virginia's Pocahontas Parkway, South Carolina's Southern Connector, the new Las Vegas Monorail, and the proposed Tacoma Narrows Bridge and California's SR 125 toll road projects.

The advantages of using a nonprofit sponsor to undertake a public/private partnership include, among other things: (a) the ability to create a governing structure that includes representatives from both the public and private sectors; (b) facilitating the transfer to the private sector of significant project risk while preserving the ability to finance the project through the issuance of tax-exempt debt if necessary; (c) insulating public agency sponsors from financial or other liability; (d) giving an affected community more direct control over key decisions and key project aspects; (e) the ability to receive and utilize federal, state and local government grants or loan proceeds; (f) enabling participation by other non-profit organizations; (g) avoiding the need for special legislation to implement a project; and (h) combining the relative strengths of the public sector with the private sector's value added efficiency and innovation in ideas.

II. Basic Characteristics

A nonprofit corporation is a private, nonstock corporation that may be formed under the nonprofit corporation act of a state. The formation does not require special legislation, nor does it require a referendum in the local or sponsoring jurisdiction. A nonprofit corporation may be formed for any lawful purpose other than for pecuniary profit, including, without limitation, any charitable, benevolent, educational, civic, or scientific purpose. No dividends are paid and no part of the income or profit of a nonprofit corporation may be distributed to its members, trustees or officers. Nonprofit corporations are regulated by the State Attorney General for compliance with the nonprofit corporation act, by state tax authorities for compliance with the requirements relating to their state income tax exemption and by the Internal Revenue Service for compliance with the requirements relating to their federal income tax exemption, and the issuance of tax-exempt debt.

When public agency members authorize the formation of a nonprofit corporation, such members can restrict the purposes or powers of the nonprofit in its certificate of incorporation. The corporation may have members, and each member may be given the right to appoint one or more trustees. The provisions of these articles of incorporation and the bylaws of the corporation may not be amended without the approval of the board of trustees.

III. Formation Of A Nonprofit Corporation

A nonprofit corporation is formed in the same manner as business corporation. One or more individuals, corporations or corporate entities may act as incorporators of a nonprofit corporation by executing and filing in the office of the Secretary of State a certificate of incorporation. The completion of the organization of the corporation includes the adoption of bylaws and the appointment of trustees and officers. The method of electing or appointing trustees may be set out in the certificate of incorporation or in the bylaws, and may include election or appointment by members or classes of members or by the board itself.

The initial bylaws of a nonprofit corporation are adopted by the board at its organizational meeting. Thereafter, the board has the power to make, alter and repeal bylaws unless that power is reserved to the members (if the corporation has members) in the certificate of incorporation or the bylaws. The members may prescribe in the bylaws that any bylaw made by them shall not be altered or repealed by the board.

IV. Governance Of A Nonprofit

Individual members of the board of trustees may be appointed by members as provided in the Bylaws of the corporation. It is also possible to include private sector representatives on the board, including directors designated by major contracting entities, chamber of commerce and other stakeholders. Thus, members on the board of a nonprofit could be designated by local mayors or city councils, regional or state agencies as appropriate.

Members of the board may serve with or without compensation, but in all events may be reimbursed for reasonable expenses. Directors and officers can also be indemnified by the corporation against third party claims as long as their individual acts were not in breach of duty of loyalty to the corporation, not in good faith or involve a knowing violation of law or the receipt of an improper personal benefit.

Members of a nonprofit corporation are usually, by statute, immune from personal liability for the debts, liabilities or obligations of the corporation.

V. Powers And Operations Of A Nonprofit Corporation

A nonprofit corporation may have broad powers to undertake activities related to its purpose, including (1) the power to sue and be sued, (2) to take and hold by lease, gift, purchase or grant any real or personal property necessary or desirable for carrying out the purposes of the corporation and to purchase, lease or otherwise acquire, own, use and otherwise deal in real or personal property, (3) to sell, covey, mortgage, create a security interest in, lease, exchange, transfer and otherwise dispose of its property and assets, (4) make contracts and guarantees and incur liabilities, borrow money, issue bonds and secure any of its obligations by mortgage or security interest in its property, franchises and income, and (5) participate with others in any corporate entity, partnership, limited partnership, joint venture, or other association, or in any transaction or arrangement which the participating corporation would have power to conduct by itself, and (6) have an exercise all other powers necessary to convenient to effect any of the purposes for which the corporation is organized.

An nonprofit would thus have the power to:

  • acquire a project site and develop it through contracts with private contractors for the design and construction of the project facilities;
  • enter into agreements with public and/or private entities for financing of the facilities; and
  • enter into agreements with third parties for operation or use of the project facilities.

VI. Financing Of The Project; Issuance Of Tax-Exempt Debt

The use of a nonprofit project sponsor could facilitate the qualification of the project to receive public funds since the revenues of the project will not inure to any private party. It may also be possible for the nonprofit to issue public or privately-placed debt if the nonprofit can enter into fixed and certain, long-term contracts for the use of the facility.

Such debt may be issued on a tax-exempt basis, which would result in significant savings in financing costs to the project. Notwithstanding the fact that the nonprofit corporation is a private corporation, it may qualify to issue tax-exempt debt if it satisfies certain IRS requirements, including those set forth in Rev. Rul. 63-20 and Rev. Proc. 82-26, as follows:

a) The corporation must engage in activities which are essentially "public in nature."

b) It must be not organized for profit.

c) The corporate income must not inure to any private person.

d) The State or political subdivision must have a "beneficial interest" in the corporation while the indebtedness remains outstanding.

e) The corporation must be approved by the State or the political subdivision, which must also approve the specific obligations issued by the corporation.

f) Unencumbered legal title in the financed facilities must vest in the governmental unit after the bonds are paid.

The rules for determining whether the governmental unit has the requisite "beneficial interest" in the nonprofit corporation are likewise quite straightforward.

a) The governmental unit must have exclusive beneficial possession and use of at least 95% of the fair market value of the facilities; or

b) If the nonprofit corporation has exclusive beneficial use and possession of 95% of the fair market value of the facilities, the governmental unit appoints 80% of the members of the board of the corporation and has the power to remove and replace members of the board; or

c) The governmental unit has the right at any time to get unencumbered title and exclusive possession of the financed facility by defeasing (paying off or providing for payment of) the bonds.

VII. Contractual Arrangements

In a project financed through a "63-20" nonprofit corporation, the non-profit corporation, rather than the private developer, will generally be the nominal owner and operator of the project. It is the party that will, from inception or by assignment, own the franchise or other development rights to develop the project; it may be the contracting party with respect to the design, construction and supply contracts; and it will almost always be the party that contracts for maintenance and operations.

The key agreements will be as follows:

Franchise or Development Agreement

Under most State privatization laws, the franchise or development agreement is the central contract under which the State or local transportation agency will grant to a private party rights to develop the toll road, rail line or other transportation project. The franchise may be awarded in response to an RFP from the government agency or as a result of negotiations with respect to an unsolicited proposal.

The parties to the franchise agreement can be (i) the governmental unit (the "Agency") and the private project proposer (the "Developer") or (ii) the Agency and the nonprofit corporation. If the Developer is the initial franchisee, it will usually assign the franchise or development agreement to the nonprofit corporation prior to closing the financing.

The franchise or development agreement will typically address the following issues, among others:

  • geographic extent of development rights
  • protection from competitive facilities
  • standards for design, construction, operation and maintenance
  • contract requirements
  • right of way acquisition
  • flow of funds
  • interoperability
  • bonding, insurance and indemnification
  • defaults, remedies and termination, and
  • lenders rights.

Project Development Agreement

The Project Development Agreement, sometimes called a Management Agreement, is the agreement between the nonprofit corporation and the Developer. This entity is sometimes structured as a limited liability company owned by the design and construction firms interested in building and/or operating the project.

Under the Project Development Agreement, a private Project Manager may act as the agent of the nonprofit corporation to negotiate and oversee the design and construction contracts (usually a design/build contract) as well as the operating and maintenance contracts. This is also the entity that will be responsible for all pre-closing tasks, such as permitting and preliminary design.

Design/Build Agreement

If the project is to be built under a design/build procurement, this contract may be entered into between the nonprofit corporation and the entity or joint venture undertaking both design and construction responsibilities. Design/build arrangements can enhance the financing because of their fixed price and completion date guarantees. (Affiliations between the Developer/Project Manger and the Design/Build team can raise conflict of interest questions that have to be appropriately analyzed, especially when the private parties have no equity at risk in the project.)

Operations and Maintenance Agreements

For tollroad projects, a toll operations agreement will be between the nonprofit corporation and a private toll operating entity, which may or may not have responsibility for maintenance of the roadway as well. These contracts must be structured to comply with the IRS "management contract" rules which restrict the term of the agreement and the ability to award incentive compensation. In some projects, the transportation agency may assume some or all maintenance responsibilities.

For a rail or transit project, the nonprofit corporation would enter into an operating contract with a private operating company. Long-term maintenance could also be part of the design-build contract.

Trust Indenture and Financing Agreements

The nonprofit corporation will issue the project debt pursuant to a trust indenture between the corporation and a trustee for the bondholders. (No other tax-exempt issuer need be involved, since the "63-20" nonprofit itself issues the debt "on behalf of" the governmental unit.) If the government is making a financial contribution or loaning any money into the project, there may also be a separate financing agreement with the Agency or a state infrastructure bank. Contractors or other private entities providing subordinated debt may also be a party the Financing Agreement.

The Trust Indenture will contain rate covenants for protection of bondholders. Either the Trust Indenture or the Financing Agreement will also contain conditions to disbursement of bond proceeds.

The trustee may or may not have a security interest in real or personal property associated with the project. The lender's basic security will be the rights of the nonprofit corporation to operate the project and collect toll revenues or fares for the franchise period under the franchise agreement.

VIII. Issues For Governmental Unit: Control V. Liability

In a "63-20" project, the Agency may face a dilemma. If the Agency wants the nonprofit corporation to perform as its true "alter ego," it may want to take steps to insure it has the ability to exercise direct control. It could do this through reserving the right to appoint directors, or requiring Agency representation on the board. Doing so, however, may subject the Agency to legal or political liability in the event the project incurs financial difficulties. As a result, many public agencies elect to minimize their formal involvement with the nonprofit corporation, treating the nonprofit corporation as if it were a private party.

Nevertheless, the Agency may desire to exercise the same degree of control over the private parties as it would were there not this intervening entity. Typically this is done by giving the Agency rights under the franchise agreement with respect to approval of contracts and subcontracts entered into by the nonprofit corporation. How strong the approval rights are may depend largely on whether the Agency or the state infrastructure bank is making its own financial contribution to the project. In addition, the Agency may require the nonprofit corporation and its contractors to meet various conditions prior to commencement of construction or acceptance of the facility upon completion. The Agency will also want detailed reporting during both construction and operations.

IX. Issue For Developer: Protecting Rights To Manage Development And Construction

Typically the Developer will play the lead role in negotiating all the project agreements, without much substantive participation by the nonprofit corporation. The Developer will generally seek very broad authority vis a vis the nonprofit corporation to manage development, construction and operation under the Management Agreement. The Agency, on the other had, is going to want to ensure that all the substantive responsibilities of the nonprofit corporation under the franchise agreement are backed by obligations of the private contracting parties under the Management Agreement, the Design/Build Contract and the Operating and Maintenance Agreements, including provision of performance bonds and guarantees.

X. Issues For Nonprofit: Avoiding Personal Liability

The initial primary concern of the nonprofit corporation is avoiding liability, particularly personal liability of its board members. They may try to obtain broad indemnification from both the Agency and the private parties. Officers and director's insurance is advisable, but sometimes difficult to get for a start-up entity. The nonprofit corporation should be represented by separate counsel, which may be the bond counsel responsible for drafting the trust indenture. The nonprofit corporation will also need some source of financial support for any pre-closing costs that are not contingent. This can come from the private entities or from the Agency.

Over the long-term, this entity will need some staffing. In some transactions, this can be provided by the Agency, which can give the Agency no small measure of practical control over the affairs of the nonprofit corporation. Alternatively, its duties will be carried out through the Developer/Project Manager, acting as its agent under the Management Agreement.

XI. Conclusion

To insure the long-term success of a 63-20 financing, the role of the nonprofit corporation must be properly understood by all the parties, including the private project sponsors as well as the authorizing governmental agency. Unlike certain prior uses of "63-20" corporations to facilitate public financings, in a public/private venture, the nonprofit corporation will not just be a passive financing conduit. It will have long-term construction and operating responsibilities.

The fact that it is not formally under the control of either the governmental unit or any private party, means that all of the parties need to pay strict attention to their contractual rights under all the project documents. And further, since in a tax-exempt transaction, the private party has no long term equity interest in the project to protect, it is important that the project contracts grant the public agency participant an appropriate measure of supervision and control throughout the life of the project.

For further information contact:

Barney A. Allison, Partner
Nossaman LLP
445 South Figueroa Street, 31st Floor
Los Angeles, CA 90071
213.612.7847
ballison@nossaman.com

     
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