Public–Private Partnerships: Protecting the General Contractor

With growing acceptance of the use of public-private partnerships (commonly referred to as P3s or PPPs) to fund, develop, construct and operate major public works projects in the United States, the question of our contractor clients is obvious: How can I participate in the potential rewards of this trend while managing my risk at an acceptable level? The answer is found in understanding the conceptual role of the general contractor in a PPP and navigating the statutory and contractual framework for the partnership.

The PPP is a tool being used more frequently by state and local governments and regional authorities to deliver vital transportation, public works and development projects to its constituents where the resources —both monetary and political—do not allow a purely publicly financed project to proceed. With the private developer and construction professionals providing a key and oftentimes primary role in conceptualizing new construction projects, PPP offers the rare opportunity for a contractor to create its own market and project. A contractor with unique expertise and innovative construction solutions is provided with the chance to structure a project that is designed around its own strengths.

As PPP gains more and more acceptance as a project delivery method in the public sector, states and the federal government are developing enabling legislation that defines the parameters of PPP and allocates risk and responsibility among the project participants. In the Mid-Atlantic Region, Virginia has actively promoted PPP development, including major transportation projects such as the Dulles Greenway and the Pocahontas Parkway. Nationally, PPP is being used currently on high-profile projects such as the Trans Texas Corridors 35 and 69, and the Chicago Skyway. All told, 22 states currently have enacted some form of PPP legislation, including Florida and California. Many of the remaining states are considering their own PPP legislation, with bills pending before the legislatures of New York and New Jersey, and the California General Assembly is considering new PPP legislation for transportation projects.

The risk profile for PPP projects varies according to the PPP statutory structure and the role of the contractor in the private partnership. For some PPP partnerships, the contractor may serve as a member of the design/build team, and undertake risk factors common to typical design/build projects. Other PPP projects can take the shape of a fast-track, fixed-price or GMP-based general contract based on a partial design. Or the contractor can serve as a partner in the private venture, undertaking not only the construction risk but the enterprise risk of project development. Other hybrids exist, each varying according to both the terms of the business deal struck between the private partners and the requirements of the state-enabling statutes. This article focuses on the role of the contractor who undertakes the risk beyond that of traditional design/build or design/bid/build.

The risk to the contractor in the PPP comes from both the contractual terms and relationship with its joint-venture partner, whether formed as a joint venture, partnership, LLC or other corporate form, and its agreement with the public entity. The contractor may also assume some of the external risks to the project normally borne by the public body. These risks are distinct.

A contractor undertaking PPP often is teaming with a financing partner who is funding the development of the project in exchange for the resulting toll revenues. The toll revenue component of the PPP is commonly referred to as the "concession." A design partner will also likely be involved, and will incur a significant portion of the conceptual phase costs. It is critical that the stakeholders mutually agree on the deal and the sharing of the risk. Another critical component of the agreement is a planned exit strategy for the contractor in the event the project encounters difficulties that make further investment not feasible or too risky. Equally critical to proper risk sharing between the private-venture partners is ensuring that the agreements between the partners collectively capture the risks transferred from the public partner, including those nontraditional risks not assumed in the design/bid/build or design/build/delivery methods, described below.

Unlike the traditional construction project where the request for a proposal is issued and the project is built by the successful awardee, the PPP proposer bears a significant risk that the project may never be built, after having incurred proposal and other predevelopment costs. On major transportation and public works projects, these costs can run into the millions of dollars. And because the PPP project proposal must encompass financing, right-of-way acquisition, traffic studies, and potential toll concessions and operation and maintenance functions, the costs of preparing the proposal should be carefully negotiated between the private PPP parties to ensure that the cost of the proposal reflects the effort and risks borne by the participants.

A PPP project can be initiated by an unsolicited proposal from the private developer. This allows a developer/contractor to craft a project to an identified need, which plays to the contractor’s strength. Unlike a solicited procurement, much of the up-front investment is expended by the developer/contractor without any assurance the project will go forward. Even if an unsolicited conceptual proposal is accepted for development, state procurement codes often allow for submission of competing proposals —which places the up-front investment by the original proposer at risk again. For this reason, state procurement codes often limit the period for competing proposals to a relatively short 45 to 60 days, to preserve the incentive to the initial offeror.

Most states provide for solicited PPP, where the public entity identifies an infrastructure need and invites private parties to compete in proposing innovative solutions. Solicited PPP is experiencing explosive market growth, as public entities turn to the private alternative to finance needed infrastructure projects. Again, depending on the state, these projects can be privately financed or publicly funded through bonds or tax revenues. The most flexible statutes allow both solicited and unsolicited proposals, such as found in the Virginia statute.

To encourage competition, states often offer stipends to unsuccessful bidders. A stipend is not without cost, however. In return for the stipend, the state usually retains the right to use intellectual property from the unsuccessful bidders. In such an instance, a contractor should be careful to evaluate whether the detail provided in its proposal is something it is willing to transfer to the ultimate awardee.

On large public works projects, such as transportation projects, compliance with environmental regulations, including the preparation of an environmental impact study, is a very significant risk to the project. The results of an environmental impact study can kill the viability of a project, require significant redesign or lead to project delay. Before significant development costs are incurred, the PPP must have confidence that the environmental permitting process will result in an affirmative "Record of Decision," or ROD. Usually, financing, procurement of construction contracts, development fees from the public partner, and other key development steps are contingent upon receipt of the ROD.

The private partner may assist in the preparation of the study, but the final assessment and study documents are best prepared (if not required to do so) by the public partner. The contractor must carefully evaluate to what extent it is assuming risk arising from an environmental-related delay or impact. Typically, the PPP will wait until environ- mental approval before negotiating the construction scope and budget because of the considerable impact the study results have on schedule and cost.

Another preconstruction risk faced by a contractor is the risk of loss of political will after a project is authorized. External pressures from interest groups, voters, public officials and others can place a project at risk of project delay or, worse, abandonment. This risk must be addressed internally with the private venture, with escape clauses that allow for exiting the process if further participation is not viable. The risk must also be managed to ensure that the party with the greatest control over political will, usually the public partner, is prepared to share the burden of costs incurred in furtherance of an approved project.

PPP projects can be financed through private debt or equity, as they are in Virginia, or through access to traditional public financing tools, as allowed in Maryland, through the bond issuing capacity of the Department of Transportation (DOT), which is reimbursed by the private partner. In either case, the private party will ultimately bear some or all of the financing risk. This is usually provided through the nonconstruction partner, but the contractor must carefully evaluate its risk in the event that inadequate financing exists (and the resulting constraints on construction funding). Alternatively, some projects may be structured with no private long-term financing, with the private party’s return on investment not coming from operational revenue, but from construction profit or a development fee paid at project completion. Federal grant and financing options are available on federally aided highway projects, including tax-exempt private activity bonds, through a program known as SAFETEA-LU. The statutory frameworks for these programs must be closely followed to ensure compliance and avoidance of unintended tax consequences.

Another role the contractor may undertake is the acquisition of the right of way (ROW) for a project. A traditional role of the public entity, PPP agreements may place the negotiation of ROW and utility relocation on the private partner, which is a potential source of significant delay. The contractor must understand its role in ROW negotiations. PPP agreements often include risk-sharing arrangements, where the public and private partners share any cost overruns in ROW costs, and split any savings. If the private partner undertakes ROW acquisition, it must retain the ability to efficiently use the full authority of the public entity to proceed with condemnation if needed.

If the private partner holds the ROW to the property acquired for the project, it faces potential tort liability for third-party injuries on the property—a significant risk for transportation projects. Governmental bodies have enjoyed sovereign immunity from such risks as the property owner, so the emergence of a property owner who could be sued for negligence makes the PPP private owner a deep-pocketed target for injured parties. Some states, in order to preserve their sovereign immunity, retain ROW rights in PPP partnerships. The state of Maryland takes this approach, with the property rights retained by the Department of Transportation. If ROW ownership is held by the private venture, by deed or leasehold, a careful review of the insurance and indemnification provisions it is vital to properly controlling the risk. It remains to be seen whether a private partner can rely on the "government contractor defense" developed in federal procurement law over the past 20 years which allows a private party to invoke governmental immunity when acting in a public capacity.

The contractor faces distinct risks during the construction phase of the PPP. The contractor most typically follows the design/build model in PPP, with the contractor teaming with a designer, who together join with a financing partner. This allows for collaboration on constructability and innovative techniques to be worked out early in project development, which is another distinction from the traditional public infrastructure procurement model.

A common element of the PPP project is the private partner’s responsibility for quality control and maintenance for an extended period beyond construction. On a highway project, for example, a general interest extends beyond just conforming to specifications for pavement quality and design. Instead, a contractor must view the state specifications as a base minimum and strive to achieve the level of quality above the minimum that will offer a later financial return on reduced maintenance and repair costs.

For example, for the Route 288 project near Richmond, Virginia, the contractor established its own specifications in excess of those required by Virginia DOT, and retained a separate quality control specialist to ensure that the build quality was meeting its own heightened standards. This private obligation to long-term quality control and maintenance creates additional risk to a contractor. In such an instance, the contractor must carefully evaluate its warranty and performance guarantees, and consider the performance and cost impact of working under a third-party quality control specialist hired for the purpose of ensuring maximum useful life of the project.

Similar to a design/build project, the PPP contractor shares in the risk of technical feasibility. But because the scope of the private venture’s overall responsibilities may be considerably more broad in PPP project, the potential challenges to technical feasibility increase proportionately. For example, can work begin prior to receipt of the environmental ROD? What if environmental prohibitions alter the planned method of construction? Can the project be resequenced or rerouted if an ROW changes? These issues require the skillful assessment and management of risk. Similarly, these technical challenges, as well as other unforeseen events, may cause a growth in scope. Traditionally, if the scope grows for a contractor, it will turn to the owner for relief. For the PPP contractor, the risk of unexpected costs must be considered in the context of a potentially constrained revenue stream from which to pay for the added scope. This requires careful contractual planning with the financing partner of the PPP.

The merging of public and private interests in the development of a private project for public use has raised, and will continue to, raise legal questions that may pose risk to project viability, or affect the financial assumptions. For example, PPP concessions can include language prohibiting the private partner from competing with a privately developed concession by opening or improving roads within a certain distance from the PPP development. Because this places a private restriction on future development of public land, political will could shift, and a change of law may invalidate such a noncompete provision, or permit competing transportation services. If such a change of law were enacted after the terms of the concession had been set, and the adjacent land were available for improving or developing competing (free) roads, the revenue assumptions upon which the project was undertaken would be at great risk. For this reason, PPP agreements typically contain "change in law" provisions that require renegotiation of the business terms or place the public entity in default. The PPP agreement must recognize this potential risk and skillfully address the impact of the invalidation of an exclusive use provision.

In addition to knowledge of the state statutes regulating PPP, the contractor must be familiar with federal statutes authorizing PPP under pilot highway projects using federal funds. To some extent, the federal program adds some predictability for the contractor by requiring use of standard federal construction clauses. For example, the lead PPP federal program on highways is the Federal Highway Administration’s Special Experimental Program 15 (commonly referred to as SEP-15), which allows tolling of federal aid highways, authorizes tax-exempt private financing, and provides specific risk allocation clauses and requirements that are imposed on PPP ventures. Among the particular requirements of SEP-15 are the following:

• regulatory compliance, including federal-level environmental permits (NEPA)

• ROW acquisition

• stipends to unsuccessful bidders

• requirements for best-value, fixed-price procurement of the private partner

The federal statutes provide uniformity, while decreasing flexibility in risk allocation, and may not necessarily align well with the state’s PPP statutes. The interaction between the federal requirement and the state regulations must be carefully reviewed to evaluate the risk-sharing provisions in each, and the impact these requirements may have on contractor performance.

PPP state statutes often strike a balance between promoting innovative project development with the public policy need of encouraging local content and open competition. Traditional procurement policies such as disadvantaged and small business set-asides may carry over in the PPP statutes. Also, some PPP regulations contain conflict-of-interest provisions of which a contractor must be aware. An example is found in the Maryland PPP statute, which bars a contractor from competing on a construction phase solicitation of a project exceeding $100 million if the contractor assisted the procuring agency prior to the decision to proceed with the solicitation.

The PPP project delivery method has garnered a reputation as being a market open only to the largest contractors willing to undertake the unique risks associated with PPP projects. But PPPs are not all the same. Each state crafts its own PPP framework, with projects ranging from multibillion roadway projects to university dormitory projects under $75 million. The opportunity exists to participate in PPP projects within customary risk frameworks by serving a construction-only role or undertaking a greater share of the risk/reward opportunity. Qualified counsel can guide the contractor through compliance with the applicable statutes, submission of proposals and preparation of contract documents. Even if it is new territory, the keys to a successful PPP project are already familiar to the contractor:

• understand and assess the overall project risk,

• ensure that this risk is fairly apportioned to the parties best positioned to control that risk and

• manage the risk throughout performance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.