Municipal bonds as a way to fund smart city projects

By Soumya Kanti De Mallik, HSA Advocates
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Government grants and multilateral agency loans will cover a mere fraction of the total cost of India’s Smart Cities Mission projects. Thus various other sources of financing are being encouraged, including municipal bonds (muni-bonds). The regulatory framework and key challenges of this funding option are highlighted below.

Soumya Kanti De Mallik, Partner, HSA Advocates
Soumya Kanti De Mallik
Partner
HSA Advocates

The Securities and Exchange Board of India (Issue and Listing of Debt Securities by Municipalities) Regulations, 2015, permit municipal bodies or a corporate municipal entity (subsidiary of the municipality formed for the purpose of raising funds) to issue muni-bonds. Smart city special purpose vehicles may not be eligible, given their shareholding pattern and that they are not set up primarily for municipal fund-raising.

Muni-bonds have been categorized as general obligation bonds (principal and interest being serviced through tax proceeds) and revenue bonds (serviced by revenues from one or more projects). The private placement route is available for both categories while a public issue can be used for revenue bonds only.

The prerequisites for a public issue are credit rating, in-principle approval for listing in stock exchanges, creation of separate escrow account for servicing revenue bonds with identified revenue streams, appointment of monitoring agency to monitor escrow account revenues, and arrangement with registered depository for dematerialization of the bonds.

Further, the SEBI regulations aim to ensure ring-fencing of the funds, continued interest by significant capital contribution of the issuer, and timely completion of projects. The proceeds of the issue can be used only for specified projects and the issuer must set up a separate project implementation cell. Also, a designated project official is to monitor the progress of the projects within the timelines and ensure that funds are used only for the projects, in line with the schedule disclosed in the offer document. The issuer must also contribute at least 20% of the project costs from its internal resources or grants, which will ensure that issuer is continuously engaged in and monitoring the projects.

The debentures must be secured by a charge on the assets or receivables, sufficient to cover the repayment amount and interest. Alternatively, unsecured debentures must be backed by a state or central government guarantee, or a structured payment mechanism requiring the issuer to deposit debt servicing amounts in a specified account at least 10 working days prior to due date.

Despite this legal framework no urban local body (ULB) has issued muni-bonds since 2010, partly because of low investor interest. Competitive interest rates, tax-free income, and security of capital and interest payout would help attract retail investors. Further, a clear policy direction to insurance and pension funds, public agencies and state-owned companies, to invest in muni-bonds as a part of their investment mandates, would go a long way in creating demand and an active market for the bonds.

A careful selection of local projects that offer substantial direct and indirect benefits to state residents may attract local people to invest, as they may be able to connect with the project, appreciate the benefits, take active interest and make local ULBs accountable for lapses.

Also, municipalities are not geared up to comply with the SEBI regulation requirements. The majority of the ULBs selected under the mission will not meet conditions such as no negative net worth for the three preceding financial years, no default in repayment of debt securities or loans in the preceding 365 days, and accounts prepared in line with the National Municipal Accounting Manual.

ULBs will need to vastly improve their technical and financial expertise and project management capabilities, so as to instil confidence, and achieve compliance with the regulations. Further, having a transparent budgeting and accounting system, and streamlined governance structures, will assist the ULBs in their readiness to access private capital through bonds.

Additionally, there are certain gaps in the legal framework. ULBs and municipal entities are required to maintain 100% asset cover to discharge the principal amount at all times for the issued bonds, which may be unrealistic as they may not always own the underlying assets.

Further, lack of municipal insolvency laws fuels the fear of a major municipal bankruptcy, as in Detroit in 2013-14, and this needs to be addressed.

If the government can plug the gaps in the legal framework, and provide the much needed push to muni-bonds, they could ensure capital flow to ULBs and smart city projects, and in turn contribute to the success of the Smart City Mission.

Soumya Kanti De Mallik is an associate partner at HSA Advocates. HSA is a full-service firm with offices in New Delhi, Mumbai, Bengaluru and Kolkata.

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