Transaction Complexity Overtaking the Institutional Capacities of the State

Case Studies

Dec 15, 2009 — Neil Boyle

Case study (2007)

 THE AIRPORT, a BOT to build and operate an international airport in an unnamed Country is an example of transaction complexity overtaking the capacities of the institutions meant to enable them. Transaction complexity came in three forms: the narrow dividing line between private ordering and corruption; an insensitive contract law regime to variations in transactions; and the impact of changes in shift parameters of the institutional environment. This BOT concession is an example of loss of economic value of a national asset that continues to lose value as this is written. The reason is attributed to organizational failure.

THE AIRPORT BOT concession with the Government of an unnamed Country (GOUC) involved a build-operate $650 million international airport for its capital city for 25 years after which THE AIRPORT would turn operations over to GOUC. THE AIRPORT is the project company owned by: the local investors (called the Local Group), and by an international Airport Management Authority of another Country, hereafter named AMAC or foreign company, one of the largest owner operators of international airports in the world. After completion of the physical construction and equipment installation, the concession was declared null and void by the Supreme Court of GOUC. No prior trial of facts was conducted by any lower court. The declaration was based on a 6 to 3 vote with the ruling decision based on non-conformance with the Constitution and existing BOT law, and the dissenting opinion claiming the Court had violated the separation of powers principle of the Constitution.  At the time of this writing in 2007 three years after declaration, the airport physical facility is completely built and equipped for operations but remains unopened. The foreign investor has sued the Local Group, and THE AIRPORT is in arbitration with GOUC. Two years ago the foreign company wrote-off over $350 million from their company balance sheet.

The Country’s Constitution limits foreign direct investment to 40 percent of total ownership equity in domestic productive assets. The Local Group was able to raise 40 percent of the equity needed; the foreign group put up the remaining 60 percent. Despite potential for a seemingly well-crafted private arrangement (i.e., privately ordered) by the local and the foreign groups to work around the Constitution (as opposed to violating it), the Court proceeded with its unprecedented declaration to terminate. 

All three branches of government judged THE AIRPORT case separately with a degree of due diligence and rigor: the Executive branch with the Office of the President’s special investigator was charged with examining all BOT contracts because of the alleged excess profits in the IP power sector; the Legislative branch with the Senate Blue Ribbon Committee was set up to examine corruption in the procurement of  THE AIRPORT deal including the implication of the Swiss Challenge that was required by law as the initial airport BOT proposal was unsolicited; and the Judiciary with the rulings of the Supreme Court in declaring the contract null and void. (There was, of course, a fourth “branch of government”, the press which also conducted its own form of examination and reporting on public policy.)

Contrary to general knowledge, two crucial constitutional laws/doctrines: the constitutional principal of separation of powers, and the constitutional principal of due process were not accorded to the Local/Foreign Group. According to the dissenting opinion of the Supreme Court, the constitution and civil laws were not duly observed. Country law points to the judicial branch as having legal responsibility to determine the facts of any case–and that within the judiciary, jurisdiction is accorded to its lower courts to carry out this task.  A logical implication and I think precedent is that neither the Supreme Court, or the Senate Blue Ribbon Committee, or the President’s Office can legally sort out the facts of the case–only a lower court can because its rules of procedure are uniquely established for that purpose. However, no lower court ruled on the case. THE AIRPORT case were tried and judged by the three branches of government none of whom had legal jurisdiction to do so. All three branches ignored the principle of separation of powers; and not one unit within any of the three branches stood as a champion for the costs and/or benefits of the public’s interest. (Three Supreme Court Justices ruled against declaring the contract null and void; six ruled in favor.)

If this observation bears up, then THE AIRPORT case may have deep and far reaching policy implications that could be very instructive for the donor community, the GOUC, and the people of the Country. One implication is that knowledge about existing constitutional and civil laws was poorly distributed throughout the state apparatus. A second implication is that if someone was sufficiently knowledgeable, they were stilled by some other factor, which raises other interesting considerations for the Government and the Country, in particular on corruption at a high level of government. A third implication confirms what is generally believed to be the case in the Country and that is the legal regulatory regime functions poorly. A fourth implication is that there were no champions of private ordering nor was there acknowledgement that contracts are incomplete. Other far reaching insights are plausible.  

Accounting for the publics’ interests

Public space is a metaphor for “public interests;” it is a term that allows for generalities to be made regarding the assessment, expansion and contraction of public goods. In THE AIRPORT case, the airport may be considered to be a public good whose interest was glossed over rather than supported or strengthened. The purpose of this note on the public interest is to answer two questions (1) How is public space protected and/or strengthened in THE AIRPORT case?, and (2) How does [A]TCE empower the analyst in this regard?

At a fundamental level of analysis public space arises when the analyst gets the diagnoses right; getting it wrong obfuscates the issue and inhibits the emergence of the problem. At an analytical level the issue of public space comes about when consideration is given to the ways and means of ensuring the public’s interests.  [A]TCE tells us that the following nine analytical considerations must be given due attention to ensure the public’s interests.

Incomplete contractspose adaptive needs for gap filling and the setting up of a mechanism for doing so that is understood and executed by both contract parties. Gap filling and its contractual mechanism requires a degree of reliable institutional competency that as a criterion for assessing a transaction must perforce include the protection and/or strengthening of public space. Exclusion of public space from any analysis of incomplete contracting and what is required to close gaps is a major oversight.

Alignment integrity—insists that analysts consider misalignments and keeping contracts from wavering too far from their original agreements, i.e., by staying on the contract curve and writing contracts that ensure they do. Such an analysis must include addressing the high degree of due diligence and internal competency that is needed by internal organization of the trading firms to make this happen.

Microanalyzing the transactioninvolves detailed description of the transaction: of what is going on at the transactional level of the exchange. To complete such an analysis, description must consider public space for each of the phases in the project cycle: procurement, negotiations and implementation. Three questions must be considered for each phase: how is PS threatened; how is the threat to PS is contained and/or mitigated; and how is public space strengthened to buffer against future external shocks? The analysis is summarized as a 3 x 3 matrix below.

Identifying who knew what when at the highest levels of governmentrequires a detailed description of what is going on at the transactional level of the exchange. In turn, such description requires explanation of why certain actions were not taken or taken. THE AIRPORT case begs the question why was the jurisdictional issue not raised by high level officials in each of the three branches of government before the start of the construction phase. The question is important enough that it should not escape analysis a second time.

Narrowing the scope of motivations for various governmental actionsgoes back to the issue of explaining why certain actions occurred. In orthodoxy, such an interest would

QUESTIONS

Procurement

Negotiations

Implementation

How is PS threatened? Myopic procurement of transaction attributes Myopic negotiation of transaction attributes Myopic execution of transaction attributes
How is threat mitigated? Farsighted procurement of transaction attributes Farsighted & bilateral negotiations of institutional supports and organizational mechanisms Myopic execution of mitigation mechanisms regardless of roles
How is PS expanded? Competent completion of related transactions

Trading of credible commitments

Maintenance of credible commitments

be glossed over. From the perspective of [A]TCE, it is pivotal as the incentives that drive human behavior are central to what [A]TCE is about. Why certain actions occurred and how to address the incentives that cause them is central to a fuller understanding of economic organization.

Assessing the performance of the Country’s legal regulatory systemin THE AIRPORT case the performance of the legal regulatory system is accounted for when conducting an [A]TCE microanalysis.

Champions of private ordering and inferences thereofprivate ordering is fundamental to the design and performance of PPP such that it must not be ignored in any analysis. In THE AIRPORT case the absence of recognizing the value of private ordering is pivotal to a full description of the transaction.  An obvious inference of the absence of private ordering is what happens when private ordering is ignored. The answer comes down to the impossibility of selective intervention on the part of the state. We know selective intervention is infeasible because of the lessons learned from the impossibility of replicating market attributes in a firm. We assume it is likewise impossible in THE AIRPORT case due to similarities between what we know about selective intervention and the case under consideration.

Politics and case summary

Politics and strategic abuse played key roles in preventing private solutions from prospering. Although numerous private submissions were made, many of them were seen hastily in the narrow context of corruption. For example, Power Purchase Agreements (PPAs) between the PPP power company serving the northern part of the Country, and independent power producers (IPPs) were only partially negotiated; one side held more cards than the other. Agreements never reached full equilibrium because of unpriced hazards and the instability they introduced. Given the weak public institutional environment at the time, the PPP power company started to unravel.   

The PPAs reflected an inherent instability in the IPP contract agreements. Although lower breakeven supply prices were entirely attainable, IPP contracts were negotiated at breakeven supply prices in excess of what prices could have been. With the appropriate tools, parties would have found contract hazards detectable and safe-guardable. Had even a small portion of safeguards been successfully negotiated in the 1990s, with the Country’s favorable political climate substantial contractual stability would have been achieved and with it lower contract prices.

Considerable money was lost on THE AIRPORT. There is little doubt that what ever is salvageable will be salvaged; nonetheless losses have been large, especially because of the non-redeployable assets that are involved. No revenue has been generated by the $650 million investment. This leaves the servicing of outstanding loans to out of pocket sources. It is believed financing was heavy with equity financing, which is an uncommon capital structure in PPP financed projects. Equity financing raises the question of whether the investors will ever see their capital investment. AMC’s writing off of $350 million signals that they are not particularly hopeful about recovering much, if anything. There have been reports about Government compensation but that is unsure and the basis is unknown. In addition to servicing outstanding loans, money is being spent on legal fees and defense counsel.  The end scenario looks something like this: arbitration ends and the original owners walk away with cents on the dollar, huge court legal fees, their asset expropriated by Government and the airport facility either run poorly by another parastatal of Government or auctioned off to the Country’s oligarchy.

Who bears the cost of the hidden risks? So far it appears that the service consumer or the taxpayer ends up paying for it through increased user charges and taxes. If proper risk management tools were available at the time (a non-trivial assumption), allocation of these risks would have been assigned to Government as the party most responsible for loss mitigation; as it turns out, opaqueness ensures that no one knows what is really going on. 

How much more fruitful the entire process would have been had the contract been conceptualized from the start as a living and fully operational document. If applied transaction cost economics [A]TCE had supplemented traditional legal and economic expertise in the formation and design of contracts, the contracts would have become far more effective operational tools to mitigate hazards and tackle economic governance. As things stand currently, contracts are legal documents that are  designed mainly for court ordered settlement of disputes; an unfortunate situation given that court ordering for this PPP is likely to turn out neither effective nor economical.

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