Lease-purchase financing offers a potential means of funding Chinese environmental infrastructure, utility systems, and other local and provincial governmental projects. In addition to other applications, benefited projects may include equipment and water, sewage, gas, central heating and electric power systems. The financing technology, applicable to a broad range of government projects, has had extensive use for many years around the world.
At present, Chinese governmental entities obtaining funding through investor-owned enterprises are paying high returns on investment. The high costs, which are passed on to consumers, may reinforce popular resistance to paying for government services. Lease-purchase financing may offer the potential to reduce those costs, and in turn to reduce consumer charges.
Equity investments in government projects are not readily understandable to investors, due to differences from common financing approaches. Traditional debt instruments – bonds, debentures and notes – while easy for investors to understand, may not receive prior central government approval.
It is important both to create structures readily accessible to local and provincial government entities and to present familiar instruments to investors. Governments may then proceed more effectively, and investors can focus their attention on credit issues.
The lease-purchase financing concept may resolve certain impediments to Chinese local and provincial government infrastructure financing. These impediments include:
- Resistance among some members of the public to payment for government services perceived as entitlements.
- A perception that there may be a cultural hesitancy by some local governments to long-term commitments.
- National concerns regarding possible local abuse, with consequent restrictions.
Lease-purchase financings may offer investors a more familiar instrument and transactional structure, increasing receptivity and reducing costs.
Leases are pre-approved by the national government. The Chinese Procurement Law permits local and provincial governments to enter into leases on their own.2 This contrasts in important respects with treatment in China of the issuance of traditional local and provincial government bonds requiring prior case-by-case approval at the national level. Many proposed bond financings simply die or are delayed.
Another possible barrier to effective financing of environmental infrastructure, perceived by some with respect to local government obligations in China, is resistance to long-term commitments. Any popular consumer resistance to paying for government services could be related, at least in part, to this concern. Shorter-term commitments of between five and ten years significantly increase periodic payments for projects. Some leases in China already are longer-term (up to 20 years) than are many traditional debt instruments.
Thus, lease-purchase financings, using longer-term lease contracts for assets with longer expected useful lives, are highly responsive to the desire to reduce costs for governmental services through lower periodic payments. By extending the terms for payment of purchase prices, local and provincial governments can achieve the lower periodic charges. That will make projects involving assets with longer expected useful lives much more affordable for middle- and lower-income persons and families who use government services. Longer-term commit-ments may be crucial to overcoming any popular reluctance that may exist to payment for essential government services.
In addition, longer terms are more equitable. When an asset has a 20-year or longer life, short-term bonds impose on today’s users the costs for assets to be used by future populations. In the U.S., that is commonly viewed as inequitable to today’s users of a government project.
User populations change, often rapidly, by dynamic mechanisms, including not only the ageing process but also migration of populations. Thus lease-purchase financings can assist in matching the costs for longer-lived assets with the populations actually using those assets.
In effect, lease-purchase financing offers a pay-as-you-go approach for public projects in China.
While lease-purchase financings offer many benefits, it is also important to avoid abuse of this potentially valuable financial tool. Critical protections for both local and provincial governments and for investors should be inherent in the application of lease-purchase financings. One such protection is the use of ‘abatement’ leases, as opposed to ‘nonappropriation’ leases. In abatement leases, a government entity is obliged to make payments unless a project’s use is denied to the entity.
As a simultaneous step in the transaction with the execution and delivery by the local or provincial government of the lease, but without direct participation of the government entity, the private lessor may deposit the lease into a trust,3 subject to a separate Trust Agreement.
The Trustee of the trust – which for investor confidence would be the trust department of a major international bank – would then divide the lease into payment streams (corresponding to the periodic rental payments), identifying principal and interest components. The principal portion of each payment stream, in turn, would be divided into denominations (e.g. $100,000).
Pursuant to that process, certificates would represent the investors’ interests (‘participations’) in the segmented payment streams. These are called Certificates of Participation, or COPs.
For investor confidence, construction contracts should be in place by the time of closing the lease-purchase transaction. Investors may need to see a fixed price contract with a reputable contractor, probably backed by a surety bond issued by a strong insurer. During a project’s construction or acquisition phase, lease payments can be made from a capitalised interest fund.
The construction proceeds (generated from the simultaneous sale of the participations in the leases) can be held by the Trustee in a construction fund for disbursement against billings for completed elements of or progress payments on the project, as approved by an inspecting project manager or architect. All funds would flow through the Trustee, so that they can easily be audited by independent accounting firms.
Except in direct lease transactions with a single lessor, the rentals under a lease would be payable to the Trustee. At the end of the lease term, the local or provincial government may own the project automatically4 or purchase it for a nominal or no price.
The lessee has an obligation under Chinese law to maintain the leased property.5 As noted, under an abatement lease, a local or provincial government is obliged to pay rentals, subject only to a project’s availability for the government’s use. If there is a calamity, such as fire or flood that damages the project so that it cannot be used for its intended governmental purpose, the local or provincial government will not be obliged to pay rent during the time the project is not usable.
To protect investors, such risks can be covered by insurance. If a project is destroyed, insurance can repay the balance of the lease principal or cover costs of replacement (with continuance of rental payments during the construction period payable from insurance proceeds).
Another risk is that of loss of ownership of a project due to a governmental taking. Any such perceived risks would appear to be diminishing rapidly, however, as China enters the WTO and the world markets and applies the rule of law. Amounts paid in connection with a governmental taking should be payable under the lease first to the investors.
For utility and other projects payable from user fees, the local government would be required to set its rates and charges to users from time to time at levels necessary to pay its periodic rentals, as well as operational, maintenance and transactional costs.
In a revenue-based project such as a water, sewage or other utility system, only the identified, dedicated revenue or other receipt stream, or another appropriate designated source, may need to be obliged contractually to pay the rentals, if demonstrated by independent audits of historical financial statements or an independent feasibility study to be feasible and adequate.
Collections from system users might or might not be administered by the lessor pursuant to a contract with the local or provincial government, subject to the local government’s oversight. For revenue-based projects, there would not be a need for the local or provincial government or its general revenues or receipts to be at risk. That would assume, of course, that there is an adequate and enforceable dedicated revenue stream to pay the rentals.
For securities sales, in order both to attract investors and to comply with applicable securities laws, detailed offering documentation likely would be required. Those documents would contain extensive information. Independently audited historical financial statements are an important source of information. Independent feasibility studies may be required for new projects. Legal opinions will be necessary as to the enforceability of the leases.
To reiterate, the widely-used lease-purchase concept has national approval in China and complies with existing Chinese law. The goal is to apply this legal, affordable, secure, and easily understood approach for financing essential governmental infrastructure in China.
- Contract Law of the Peoples Republic of China (the“Contract Law”), Ch.13—Contracts for Lease and Ch. 14—Contracts for Financial Lease. See generally, Ch. 14, Arts. 237-42.
- Art. 2 of the Procurement Law defines Government Procurement as “the procurement with compensation of merchandise, projects or services by a government or governmental agency,” and defines Procurement as “procurement of merchandise, projects or services through contracts, including purchasing, leasing, … .”
- The lessor may be a Chinese entity specially-created for the transaction. The entity may then assign its interests as lessor to the Trustee, which then may accept the interests on behalf of the investors.
- Contract Law, Ch. 14, Art. 250.
- Contract Law, Ch. 13, Art. 247.