Land Development

The sale of land and buildings owned by a public authority conforms with the market economy operator principle when i) it is profitable, ii) there is no alternative transaction that is economically more attractive, and iii) the sale is as profitable as similar transactions concluded at the same time.

 

Introduction

The article examines Commission decision 2015/507 concerning the sale of a plot of land together with buildings in Germany.[1] The decision provides useful guidance on how to establish whether a public authority engaging in land transactions acts as a market operator. The decision concludes that the transactions in question were free of State aid, but then goes on to argue that if there were any State aid it would have been compatible with the internal market. While the Commission’s assessment of the existence of State aid is robust, I will suggest that its reasoning concerning the compatibility of any aid is weak and possibly contradictory. To put it simply, if it can be shown that a project can be carried out by a market operator, how can it be argued at the same time that the market fails to fund the project?

Background facts

In March 2007, Neubrandenburger Wohnungsgesellschaft [NEUWOGES] submitted a complaint to the Commission alleging that illegal State aid had been granted to Bavaria Immobilien and two other special purpose vehicles for land transactions [BAVARIA and BAVARIA 1 & 2]. The alleged aid was in the forms of a land-lease and sale contract and a general management contract.

In November 2008, a regional court in Germany ruled in a case brought by BAVARIA against NEUWOGES for failure to comply with a contract between them. NEUWOGES had claimed that the contract involved illegal and incompatible State aid and was therefore void. The regional court found that no advantage had been conferred to BAVARIA and there was no State aid.

In July 2009, the Commission considered that neither the land-lease and sale contract, nor the general management contract constituted State aid. After more information was submitted by NEUWOGES, the Commission decided in March 2012 to open the formal investigation procedure.

NEUWOGES is a limited liability company with the City of Neubrandenburg holding 100% of its shares. NEUWOGES provides affordable housing in Neubrandenburg and the surrounding areas. NEUWOGES owns 33% of all housing and a number of plots of land in the City of Neubrandenburg.

BAVARIA 1 and BAVARIA 2 are property companies that were specifically founded for transactions with NEUWOGES and are majority-owned by closed real-estate funds. BAVARIA 1 is owned by BAVARIA Immobilien GmbH. BAVARIA 2 is wholly owned by Perseus Immobilien Verwaltungs GmbH & Co. KG.

In January 1998, NEUWOGES and BAVARIA concluded a land-lease and buildings sale contract for 12 buildings with a total of 557 individual flats. Under that contract, BAVARIA obtained a lease on the land for 75 years and bought the buildings. The payment made by BAVARIA was in two components: a capitalised rent on the land up to 31 December 2028 and a purchase price for the buildings. From 1 January 2029, BAVARIA will also have to pay an annual rent for the land.

NEUWOGES argued that, in concluding the contracts, it did not behave like a market economy operator [MEO] and thus granted BAVARIA State aid.

Possible existence of State aid

The Commission began its assessment by reiterating the principles that apply to the behaviour of a market operator [paragraphs 97-101]:

  1. The hypothetical market operator must be in a situation as close as possible to that of the State.
  2. Only the benefits and obligations linked to the capacity of the State as shareholder — to the exclusion of those linked to its capacity as a public authority — are taken into account.
  3. It is for the Member State that relies on that principle to establish unequivocally and on the basis of objective and verifiable evidence that it took the measure in its capacity as an economic operator.
  4. That evidence must show clearly that, before or at the same time as conferring the economic advantage, that Member State took the decision on the basis of economic evaluations in order to determine the future profitability of the investment.
  5. It is not enough to rely on economic evaluations made after the advantage was conferred, or on a retrospective finding that the investment made by the Member State concerned was actually profitable.

The Commission’s assessment comprised three steps:

  1. The financial implications of the transaction for NEUWOGES were analysed to determine what profits it could expect to obtain from the transaction.
  2. In order to determine whether any available alternative would have been economically more attractive, the sale-and-lease-back transaction was compared to other options, such as a direct sale.
  3. A benchmarking exercise was carried out by comparing the transaction in question with similar sale-and-lease-back transactions concluded around the same time.

As a first step, the Commission calculated the possible financial outcomes of the contracts for NEUWOGES. For this purpose it used the formulas of NEUWOGES itself for determining leases and rents. Then the Commission examined whether the assumptions and market expectations of NEUWOGES were realistic. It found that indeed they were realistic. It concluded in paragraph 152 that “the expectations expressed by NEUWOGES in its original calculation cannot be said to have been unreasonable. Accordingly, in light of the evidence presented, it was reasonable for NEUWOGES to expect to make a profit”.

The words used here by the Commission are significant. The Commission does not argue that it has proved that those calculations were the exact calculations that a profit-maximising investor would have carried out. It only suggests that there is no strong evidence to reject them for being clearly unrealistic or unreasonable.

As a second step, in order to determine whether NEUWOGES’ decision to engage in the sale-and-leaseback transaction fell within the range of economic behaviour that a rational market economy operator would have reasonably engaged in, the Commission compared the value of that transaction to that of alternative business options. The logic here is that if NEUWOGES had had an alternative that was economically more advantageous, the decision to engage in the sale-and-lease-back transaction would not have been taken by a MEO.

In the connection, the Commission considered, in paragraph 156, that neither renting the buildings without first modernising them, nor demolishing them, would have been viable business alternatives. “First, renting without modernisation would have resulted in limited revenues, and it was clear that unmodernised buildings would more often be left vacant than modernised buildings. There is thus no solid basis for concluding that the profits derived from continuing to rent unmodernised buildings could have been expected to exceed those obtained under the sale-and-lease-back transaction. Likewise, demolition would have created no revenue, but would have involved demolition costs. Thus, nor can demolition qualify as a viable alternative at the relevant time.”

However, NEUWOGES could have obtained a loan to finance the modernisation of the buildings by itself. In relation to this point, the Commission noted that NEUWOGES would have to increase its debt to a level that the board had considered unacceptable. In the alternative, it would have to commit an amount of capital that it did not have at its disposal at the time.

A third alternative would be to sell both buildings and land. The Commission’s calculations showed that the proceeds from outright sale were a bit higher than the value of the contract with Bavaria. Nonetheless, the Commission argued that “this small difference does not mean that a MEO would have necessarily chosen the outright sale alternative”. [paragraph 169]. This is because under the contract, Bavaria would return the land to NEUWOGES after the lease would end in 75 years and because marginal changes in the assumptions underlying the calculations could eliminate the small difference between the value of the contract and the estimated value of outright sale.

As a third step, the Commission carried out a benchmarking exercise by examining, “as a precautionary measure”, whether the transaction corresponded to other contracts at the same time in the same market and whether there were other indications to undermine the Commission’s conclusion that the sale-and-lease transaction was in conformity with the MEO principle.

Its conclusion was that the NEUWOGES/BAVARIA deal was within the range of transactions that a MEO would reasonably have engaged in. The comparison with other contracts and financing instruments suggested that the deal conformed to market conditions at the time.

In order to be on the safe side, the Commission also considered whether, had the contract involved aid, the aid would have been compatible with the internal market. The contract satisfied all the remaining criteria in Article 107(1), so if BAVARIA had obtained an advantage, it would have constituted State aid.

The Commission assessed the compatibility of the aid directly on the basis of Article 107(3)(c) and examined whether:

  1. the aid measure served a well-defined objective of common interest
  2. it was an appropriate instrument for achieving that objective
  3. it was necessary and had an incentive effect
  4. it was proportionate, and
  5. it did not affect trading conditions to an extent contrary to the common interest.

Below I present the gist of the Commission’s assessment but also add a number of comments concerning the robustness of that assessment.

  1. Objective of common interest: Because of NEUWOGES’s statutory obligation to secure sufficient housing supply, the Commission considered that, through the transaction in question, NEUWOGES pursued certain public policy objectives.

Comment: Earlier the Commission was satisfied that NEUWOGES had behaved as a market operator. Now it presumes that it is acting as a public authority. Just because the transaction increased the supply of housing must it be concluded that NEUWOGES was actively pursuing a public policy objective? Was the housing in question the type of housing that best met the housing needs of the local residents?

  1. Appropriateness of the measure: The transaction in question ensured that the buildings bought by BAVARIA were comprehensively modernised, leading to an increase of supply of quality housing in the region.
  1. Necessity and incentive effect: According to the Commission in paragraph 216, “BAVARIA would not have entered into a transaction that did not fit in with its ‘real-estate leasing model’. If the transaction that was eventually concluded, which was based on BAVARIA’s ‘real-estate leasing model’, involved State aid, then there is no doubt that, without this aid, BAVARIA would not have engaged in the transaction.”

Comment: This reasoning is weak. “Necessity” means that there is a market failure. Market failure, in turn, means that the market does not produce the desired outcomes from a public policy perspective. The Commission by proving earlier that the transaction was MEO-conform, in effect demonstrated that a hypothetical investor would have been willing to carry out the project. Why is that? Because if the price charged for the land and buildings was too high, no market operator would have been willing to buy them. Where, then, is the market failure? Furthermore, to demonstrate the existence of an “incentive effect” it is necessary to define a counterfactual – what BAVARIA would have done without the aid. BAVARIA negotiated long and hard to get the best deal out of the project. This does not, however, establish what BAVARIA would have done without the aid.

But, more importantly, from where would the State aid come in this case? The Commission does not pose or answer this question. The most likely source of State aid is the difference between the sale value of the land and buildings and the price paid by BAVARIA. In other words, BAVARIA could have benefited from State aid had it obtained state-owned assets at a price below their market value. But if the market value was higher than the price paid by BAVARIA, then there was no market failure! Any other market operator would have been willing to carry out the project by paying a slightly higher price than BAVARIA.

 

  1. Proportionality: In paragraph 217, the Commission reiterated that the policy objectives pursued by NEUWOGES were “important” and then asserted that “the amount of aid in favour of BAVARIA contained in the sale-and-lease-back transaction – if any – was, at most, limited – a state of affairs that also limited any distortion of competition by the measure. In this light, any aid that may have been contained in the sale-and-lease-back transaction between NEUWOGES and BAVARIA was proportionate to the objective pursued.”

Comment: The reasoning on this point is weak too. First, the importance of the policy objective of the public authority in question is irrelevant to the issue of proportionality which is about the minimum amount of aid that is necessary to induce the beneficiary to undertake the aided project. Second, without knowing how much aid was involved in the transaction it is impossible to prove that that was the minimum that BAVARIA needed to carry out the project. In fact, if NEUWOGES granted aid to BAVARIA because a market operator would have charged BAVARIA a higher price, then it is at the same time shown that, had BAVARIA been an efficient undertaking, it would have been willing to pay the market price for the land and buildings because, presumably, it should have been able to make a profit even at a higher price. This reasoning demonstrates both the absence of incentive effect and that any aid, even small, would have been disproportional.

But assume for the sake of argument that there was aid in the transaction. NEUWOGES could have granted such aid by charging a price for the land and buildings, say P, which was below the market rate, say Pm. That is, State aid, S, is S = Pm – P, or Pm = P + S. How can we establish whether S was proportional? We know that BAVARIA made a positive profit. Let profit be F, which is equal to R (which is expected revenue) – C (which is cost of renovation) – P (which is cost of purchase = price of purchase) or F = R – C – P. If aid was necessary, then by applying the funding gap approach that the Commission has developed in order to determine the proportionality of aid to infrastructure projects, a proportional amount of aid is Sp = C + Pm + Fr – R, where Fr is the amount of “reasonable profit”. In other words, Fr = R + Sp – C – Pm. By substituting Pm in the equation for Fr we get Fr = (R – C – P) + (Sp – S). By substituting (R – C – P) we get Fr = F + Sp – S. This leads to the following, Sp = Fr – F + S. This demonstrates that if Fr = F, then Sp = S. That is, the amount of aid in the difference between the market price Pm and the price actually paid P is proportional. However, if the actual profit of BAVARIA F is larger than the reasonable profit Fr, then the amount of aid that is proportional must be less than the amount of aid in the difference in prices. We see that proportionality does not depend on the whether the aid is large or small but on what is necessary for the project to be carried out.

  1. No effect on trading conditions that is contrary to the common interest: The Commission asserted, in paragraph 218, that “since BAVARIA’s competitive position would thus have been only marginally improved [because of the small amount of aid], it can be concluded that the sale-and-lease-back transaction, even if it contained aid, did not affect trading conditions to a degree contrary to the common interest.”

On the basis of the above rather doubtful statements, the Commission concluded that any aid would have been compatible with the internal market.

Conclusions

This is a textbook decision that gives ample guidance on how to establish whether a public authority acts as a market operator or private investor. At the same time it reveals the risk of attempting to prove both that a measure is free of State aid and that if any aid exists it is compatible with the internal market. This is an approach that Member States often attempt without much success because the Commission can easily identify the logical inconsistencies of acting both as a private investor and as public authority. Yet, surprisingly, the Commission has done exactly the thing it often criticises.

———————————————————————–

[1] The decision is published in OJ L89, 1/4/2015 and can be accessed at:

http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=uriserv:OJ.L_.2015.089.01.0037.01.ENG.

 

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About

Phedon Nicolaides

Dr. Nicolaides was educated in the United States, the Netherlands and the United Kingdom. He has a PhD in Economics and a PhD in Law. He presently holds positions at the College of Europe and the University of Maastricht. He has published extensively on European integration, competition policy and State aid. He is also on the editorial boards of several journals. Dr. Nicolaides has organised seminars and workshops in many different Member States, and has acted as consultant to several public authorities.

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