Recently, the Russian press has been actively discussing infrastructure bonds. This is primarily related to the initiative of the Russian Government to follow the example of some countries and finance the construction and operation of infrastructure facilities using so-called infrastructure bonds.
Thus, the government's anti-crisis measures program includes the placement of infrastructure bonds by Russian Railways (on January 29, 2009, the company registered 7 bond issues which it positions as infrastructure bonds. However, Russian Railways bonds are not infrastructure bonds, as the offering documents do not provide for guarantees of targeted use of raised funds, security for the bonds from revenues generated by the infrastructure facilities, and other provisions characteristic of infrastructure bonds. Corporate bonds issued to raise funds for the implementation of an infrastructure project are also mistakenly understood as such.
Indeed, in established global practice, financing of an infrastructure project is carried out through the issuance of bonds, alongside loans and state subsidies. Such bonds are divided into project bonds, revenue bonds, and general obligation bonds. This division depends mainly on who the issuer is (a private company or a public entity), as well as on the security for the bonds and the resulting features. These types of bonds are often collectively referred to in economic literature and journalism as "infrastructure bonds".
This article briefly describes these types of bonds and examines the current proposals for attracting financing through bond issuance for infrastructure facilities in Russia.
PROJECT BONDS
General Characteristics
Project bonds are securities issued by a private project company that owns the infrastructure facility (under construction or already built), payments for which are made from revenues generated by the operation of the infrastructure facility, and whose offering documents contain covenants allowing the bondholders (and their representatives) to monitor circumstances that materially affect the cash flow of the financed infrastructure project.
The project company is controlled by a sponsor – the entity initiating the construction and operation of the infrastructure facility. The project company holds the rights of claim under contracts for the operation of its infrastructure facility, which it provides as security for obligations under the raised loan, including issued project bonds. The project company controls the progress of construction work on the infrastructure facility by the contractor and, after commissioning, manages it.
Collection of payments for use (from which obligations under project bonds are fulfilled) from end users of the infrastructure facility is carried out by facility operators appointed by the project company.
Holders of project bonds have the ability to control the activities of the project company by granting the bondholders' representative the right to receive from the project company and operators any information regarding the operation of the infrastructure facility. Furthermore, the bondholders' representative may be elected as a member of the project company's board of directors to be able to control the election of the project company's sole executive body.
Project Bonds and State Support Measures
The project company is established within the framework of both purely private projects and public-private partnership projects. In the latter case, the project company typically acts as the concessionaire under a concession agreement with the state (the concedent).
The state often participates in projects requiring long-term construction of capital-intensive infrastructure facilities of significant social importance, or in projects where the type of infrastructure facility is new. In doing so, the state usually assumes only a portion of the credit risks related to the infrastructure facility by providing state support measures.
The most commonly used state support measures are:
1. providing a state guarantee for the obligations of an insurance organization that insures the issuer's risks on its obligations to bondholders;
2. providing a state guarantee within the framework of a concession agreement (guaranteeing a certain level of revenues from the operation of the infrastructure facility, a certain level of exchange rate, etc.);
3. tax benefits;
4. providing a state guarantee for project bonds.
Such state support measures significantly enhance the credit quality of project bonds (although they do not directly guarantee the bond obligations, as they are aimed at ensuring a certain level of profitability of the infrastructure facility (payments on project bonds are secured by revenues from the operation of the infrastructure project).
The credit quality of state support measures depends on characteristics such as: performance conditions (e.g., whether additional approval for budget expenditures is needed for payments under the state guarantee; whether a default event on the bonds is necessary for payments under the state guarantee or a preliminary notice of insufficient funds for bond payments is sufficient); the priority of performance under the state guarantee; political risks associated with the implementation of the infrastructure project (e.g., political support for certain projects may significantly decrease during an election campaign).
ON THE TERM "INFRASTRUCTURE BONDS"
The Russian term "инфраструктурные облигации" (infrastructure bonds) is formed by a calque translation of the phrase infrastructure bonds, which is used in both economic and legal meanings. In literature dedicated to infrastructure project financing, this term often denotes all bonds issued to finance an infrastructure facility (infrastructure bonds in the economic sense). In a strictly legal sense, the term infrastructure bonds is used in the legislation of some US states and denotes those bonds issued exclusively for financing the construction (acquisition, reconstruction) of an infrastructure facility.
However, the more common legislative term in the US for bonds used to finance an infrastructure project is revenue bonds.
REVENUE BONDS
Characteristics of Revenue Bonds
Issuer
Revenue bonds are bonds issued by public-law entities (the state, municipality) and/or public legal entities (legal entities established by a public-law entity or in whose charter capital it has a predominant participation, as well as legal entities performing any public functions (based on an agreement with a public-law entity or a license) (hereinafter – public entity).
Security
Revenues from the operation of the infrastructure facility (tax revenues, duties, tariffs, etc.) are provided as security for such bonds. The property of the public entity, as a rule, does not secure the obligations under revenue bonds.
Unlike project bonds, this type of bond can be secured by revenues from the operation of not only the infrastructure facility for which they were issued but also from other infrastructure facilities owned by the public entity.
Tax Neutrality
An important advantage of revenue bonds is the regime of tax neutrality. According to it, income from revenue bonds is not subject to taxes at both the federal and local levels. This significantly reduces the interest rate on revenue bonds and thereby reduces the costs for the public entity.
Structure of a Revenue Bond Issuance Transaction
Generally, the procedure for issuing revenue bonds occurs as follows.
The sponsor (the entity that initiated the construction and operation of the infrastructure facility) and simultaneously the issuer of the revenue bonds are state/municipal bodies or state/municipal legal entities. Collection of revenue generated from the operation of the infrastructure facility can be carried out (a) either by the sponsor into a separately designated account for this purpose, (b) or by the representative of the bondholders, (c) or by an operator appointed by the sponsor.
Revenues from the operation of the infrastructure facility are the primary source of payments and security for the issuer's obligations under the revenue bonds. The infrastructure facility is not transferred as security for the obligations under the revenue bonds and remains with the public entity.
In the US, a public entity (sponsor) may enter into an agreement with a private company (developer), pursuant to which the private company obtains the right to operate the infrastructure facility. In this case, payments to the private company under such agreement are directed towards paying interest and redeeming the revenue bonds. Ownership of the infrastructure facility remains with the public entity. Upon expiration of the agreement with the public entity, the private company has the right to purchase the infrastructure facility provided it has fulfilled all terms of such agreement.
Furthermore, thanks to municipal programs for financing infrastructure facilities, a private company has the right to initiate the construction and operation of an infrastructure facility, as well as the issuance of revenue bonds. Based on such programs, the public entity selects the private company whose application best meets the requirements set forth in the program. The issuers of the revenue bonds and the owners of the infrastructure facility are public entities.
Advantages for the State
The issuance of revenue bonds is one way to attract private investment into an infrastructure project. However, such bonds constitute only a part of the overall infrastructure financing structure, which usually provides for federal and sub-federal subsidies, private investments in the form of direct participation in the project (through a concession), and lending.
An important advantage of revenue bonds as a debt instrument is that the property of the public entity, except for revenues from the infrastructure facility, is "protected" from the claims of holders of revenue bonds. Moreover, the main obligations of the public entity under revenue bonds are limited to monetary obligations. Bondholders do not receive any participation interest in the financed infrastructure facility.
Significance for Private Investors
Investing in revenue bonds offers advantages for private investors such as reduced tax burden on bond income and a significant reduction in legal risks associated with the status of the issuer, the bond issue, and the use of raised funds:
- income from revenue bonds is not subject to taxation;
- a significant reduction in legal risks occurs due to the legislative enshrinement of the main elements of the transaction structure:
- the issuer's right to issue bonds;
- the provision of revenues from the infrastructure facility as security;
- the targeted use of revenues from the infrastructure facility as security.
Thus, legislative regulation prevents the possibility of the revenue bond issuance transaction being declared invalid. And any non-targeted use of revenues from the operation of the infrastructure facility securing the bonds is invalid.
Legislative Regulation of Revenue Bonds
Special legislation dedicated to revenue bonds exists in states such as the USA and Poland. Legislative norms on revenue bonds typically regulate the following issues:
- granting public entities the right to issue revenue bonds;
- enshrining the exclusive designated purpose of the security provided for the bonds (i.e., revenues from the operation of the infrastructure facility) for the performance of obligations under the bonds, as well as prohibiting the foreclosure on such security for claims not related to obligations under revenue bonds, including in case of bankruptcy of their issuer;
- the procedure for making the decision to issue revenue bonds;
- prohibiting claims against the public entity regarding its property that was not provided as security for the revenue bonds (primarily, regarding the public entity's budget revenues);
- special rules of budget legislation regarding the issuance and circulation of revenue bonds;
- some conditions for the issuance of revenue bonds;
- methods of financing the public entity to provide it with the necessary funds for the emission of revenue bonds.
The enshrinement at the legislative level of the main elements of the revenue bond issuance transaction structure (rules on the issuer, on the security for the bonds, etc.) is a substantial guarantee of investors' rights, as it eliminates possible disputes and uncertainty in the realization of their rights, expressly enshrined in law. This, in turn, predetermines a fairly high credit rating for revenue bonds.
General Obligation Bonds
Not only revenues from the operation of the infrastructure facility but also all property of the public entity (issuer) can serve as security for bond payments. Such bonds are called general obligation bonds. To make payments on them, if revenues from the operation of the infrastructure facility are insufficient, other property of the issuer is used (primarily, tax revenues of the budget).
To decide on the issuance of general obligation bonds, approval from the legislative body is usually required (approval in a referendum, consent of the authorized higher body), as this establishes additional expenditure obligations of the budget.
As a rule, general obligation bonds are issued in cases where it is necessary to ensure financing for large, costly projects over a long term.
PROPOSED BOND MODELS FOR INFRASTRUCTURE PROJECT FINANCING
Currently, a number of measures have been adopted in Russia to introduce so-called infrastructure bonds into circulation. These proposals, including the report of the Russian Ministry of Economic Development on infrastructure bonds, are based on a model according to which the issuer of the bonds is a private legal entity (a concessionaire implementing an infrastructure project based on a concession agreement). Thus, the Federal Service for Financial Markets proceeds from the understanding of infrastructure bonds as securities with a long maturity, performance of which is secured by a state guarantee or a guarantee from the state corporation VEB.
However, for such "infrastructure bonds", targeted use of such bonds, securing bond payments with revenues from the infrastructure facility, and mechanisms for disclosing information on the progress of the infrastructure project implementation, which should allow bondholders to control the necessary level of revenues for bond payments, are not provided for. Therefore, the proposals of the FSFM regarding infrastructure bonds actually refer to corporate bonds. However, corporate bonds and infrastructure bonds are two fundamentally different instruments.
The former are a type of financing provided "against" the general financial position of the borrower (issuer), i.e., bond payments are made from the issuer's operating revenue, not from a specific source. In contrast, infrastructure bonds are a type of financing where lenders assess risks associated with a specific infrastructure project, since bond payments are made from revenues generated by the operation of the infrastructure facility.
NECESSARY LEGISLATIVE CHANGES IN RUSSIA
The financing instruments described above: project bonds issued by private companies, and revenue bonds issued by public entities – can be used in Russia provided amendments are made to a number of regulatory acts. Such legislative changes must, firstly, enshrine in legislation norms allowing the implementation of the basic principles of project financing, and secondly, ensure the issuance of infrastructure bonds.
Implementation of the Basic Principles of Project Financing:
- Expansion of the subject matter of security for securities. Currently, securities legislation allows only two types of property to be provided as security for securities: securities and immovable property. This list should be expanded, and any property, except property prohibited from circulation, should be permitted as the subject of security for securities. Thus, within project financing, rights of claim under contracts for the operation of the infrastructure facility (lease payments, tolls for road use, airport fees, port handling tariffs, etc.) are usually provided as security;
- Exclusive business purpose of the project company. The exclusive business purpose of the project company allows project investors to control the circle of persons who can make claims against the project company. Such control significantly reduces the credit risks of project investors, as it eliminates the possibility of claims being made against the project company by persons not involved in the infrastructure project implementation process. Furthermore, it eliminates the possibility of the project company improperly disposing of property involved in the infrastructure project (primarily, the infrastructure facility);
- Restriction of the possibility of reorganization, liquidation, and initiation of bankruptcy proceedings against the project company. To ensure proper performance of obligations to creditors, the project company must exist until all its obligations to creditors are fully performed. Therefore, it is necessary to introduce the possibility of restricting the right of the project company to initiate its reorganization or liquidation. Moreover, it is required to limit the circle of persons entitled to file an application with the arbitrazh court to declare the project company bankrupt;
- General meeting of bondholders and representative of the bondholders. The general meeting of bondholders is necessary primarily for (a) the possibility of amending the bond terms and conditions and (b) making decisions on applying specific legal remedies for the rights of bondholders. Thanks to the general meeting, it becomes possible to adopt decisions binding on each bondholder, including those who voted against such a decision.
The representative of the bondholders will act on behalf of all bondholders, which will allow (a) the issuer to interact during the circulation period of project (infrastructure) bonds with one entity (and not with all bondholders) and (b) the protection of the rights and interests of bondholders in the most prompt and professional manner (e.g., when foreclosing on the security for project (infrastructure) bonds).
Ensuring the Issuance of Infrastructure Bonds:
- the possibility of issuing infrastructure bonds by relevant bodies in the infrastructure sphere. It is necessary to grant the right to issue bonds to state (municipal) bodies performing state functions (functions of local self-government) in the relevant infrastructure sphere (e.g., the Ministry of Transport of the Russian Federation, a governing body of a constituent entity of the Russian Federation, and a local self-government body in the road sector). This will significantly reduce the time for making decisions or performing actions required during the circulation period of infrastructure bonds (e.g., approval of disclosure documents);
- segregation of budgetary funds within the infrastructure project. When issuing infrastructure bonds, the offering documents of which provide for the management of the infrastructure facility by budgetary institutions, accounting for revenues and payments related to the infrastructure facility must be conducted separately from all other budgetary funds of the corresponding budget (while preserving the possibility of budgetary control). This measure is aimed at preventing the commingling of income from the use of the infrastructure facility in state (municipal) ownership (which are provided as security for infrastructure bonds) with other budget revenues;
- securing payments on infrastructure bonds through regulated tariffs. To provide issuers of infrastructure bonds with the ability to cover shortfalls in funds for payments on infrastructure bonds in case of a decrease in the amount of regulated tariffs collected from the operation of the infrastructure facility, legislation must provide for the right to establish in the offering documents the procedure and conditions for changing (including increasing) regulated tariffs during the operation of the infrastructure facility without the need to obtain special permission from the body in the sphere of state price (tariff) regulation for goods (services) (Federal Tariff Service);
- absence of taxation on income from payments on infrastructure bonds. It is necessary to establish in the Tax Code a tax rate of zero percent on profit from interest on infrastructure bonds, as well as profit from the sale of infrastructure bonds by their holders.