No-one expects their project to end up in default. Extensive due diligence exercises, well drafted project and finance documents, built in contingencies and captured political will convince many participants that negotiating termination provisions is arguing over angels and pinheads. But much of the lawyer’s time is dedicated to the question “what if” and the consideration of the unthinkable in projects that could span over a period in excess of thirty years. . Out of the contemplation of this question has arisen some complex and not so complex solutions to the measure of compensation payable to the project company by the off-taker or public sector sponsors on the termination of major infrastructure projects. And the most difficult question of all for financiers and off-takers to answer is “What if the project company fails?”.
This article considers some of the accepted and proposed solutions to the thorny issue of project company default in project financed infrastructure projects and, in particular, the calculation of payments to be made from one party to the other in these circumstances.
Assuming a limited recourse structure for the project, upon a termination of the project, two major competing and opposed interests emerge from the ashes – the lenders and the off-taker / conceding authority (referred to as the “off-taker”). Firstly, on a termination for any reason, the lenders will have lost the main source of cashflow from which the loan made available to the project company was to be repaid. If the termination occurs right at the end of the construction period (for example because of a failure to complete the construction of the asset by a construction completion cut-off date in the main project document) then it is likely that the exposure of the lenders to the project will be at its maximum.
If the project company has defaulted, political insurance proceeds are insufficient to repay the outstanding loans and all of the reserves and other cash resources dedicated to the project have been utilised, the only other possible source of cash is the off-taker. This is why the termination compensation provisions for the lenders play a crucial role in the assessment of the bankability of the project.
The off-taker may question why it should even consider paying compensation to a failed project company on the termination of the project. Indeed, logic would dictate that the project company should, assuming that it had the means available to it, pay compensation to the off-taker. The off-taker could be left picking up the pieces where a half constructed project is dumped on it or the need to find an alternative operator for the project if termination occurs after the construction phase. In either case, it is likely to incur substantial costs either in demolishing what has been built and restoring the site, completing construction or running a tender process to find an alternative operator.
Nevertheless, on a termination of the PPA or the concession agreement due to the default of the project company, it is normally the case that all assets, rights and interests to the project (whatever state it may be in) will revert to the off-taker. Lenders often run the argument that as the assets revert to the off-taker, the off-taker should pay an amount in respect of them fixed by reference to the outstanding liabilities of the project company owed to the lenders. The argument goes, that without such a payment, the off-taker will be unjustly enriched on the transfer of the assets and hence positively encouraged to ensure that the project company fails in order to get its hands on a free, revenue generating asset. This argument is fine as far as it goes, however, it is difficult to see how an off-taker could be unjustly enriched by taking over the liabilities and costs associated with a half completed project or a project that has not been designed, constructed, operated and maintained correctly.
Furthermore, lenders are often given the benefit of certain step-in rights by off-takers to take over the project from a failing project company. These rights are often insisted on by lenders, however, where is the incentive for these rights to be exercised if the lenders know that ultimately, the outstanding debt is underwritten by the off-taker? The off-taker is entitled to ask whether the project in these circumstances is truly limited recourse and justifies the high lending costs charged by the lenders. There may also be genuine concerns on the part of the off-taker as to the accounting treatment to be given to the project on its balance sheet.
The truth of the situation is that, ignoring the rights and wrongs of the arguments, the issue comes down to a question of financeability in the context in which the project sits. What one lender is prepared to accept for an availability based accommodation project in the UK with a relatively stable payment stream and a developed market, will be completely different from what would be acceptable for a water concession project in a west African country. Governments in emerging markets may therefore be forced to decide between the natural urge to limit their liabilities on a termination to the maximum extent possible and a more general policy consideration relating to the attraction of inward investment in their infrastructure sectors on a continuing basis. Of course, there is a fine balance to be struck between these competing considerations.
Examples of Compensation Regimes on Project Company Default
(a) UK DBFO Roads
The UK Model Contract for DBFO road projects (i.e. projects with shadow toll / availability / congestion management payment mechanisms) represents the extreme end of the termination compensation provisions that the writer has encountered. No compensation is payable where the DBFO contract terminates due to the default of the project company. Many attempts were made on behalf of lenders to try to modify this position, however, the UK government calculated that competition between consortia bidding for the projects and among lending institutions was such that this position was sustainable and would not prevent the projects from being financed on a limited or non-recourse basis. After the provisions had been accepted by one consortium and their lending group, the position was, as far as the government considered, a standard and financeable position. After the initial tranche of projects was financed, no further discussion of the position was entertained by the government and their advisers. A number of reasons were given on behalf of the government for its position, including, the need to encourage the lenders to make use of their step-in rights under the direct agreement for the project. While the end result was undoubtedly a victory for the government, an extremely extended negotiation process for each of the initial projects resulted. Huge amounts of time and energy (and fees) were spent arguing over each of the specific grounds of termination of the contract and the terms of the direct agreement. In subsequent tranches of road projects in the UK, the position was adopted largely without question.
(b) Other PFI Projects
Outside of the roads sector, an entirely different approach to the issue has been adopted in the UK, which has also been used in the South African PPP market. This is characterised in accommodation based projects as a re-tendering or valuation exercise. The basic mechanism calls for the project to be re-tendered to the market following a termination due to a project company default. The re-tendering is to be carried out by the public authority pursuant to a procedure defined in the DBFO agreement and is only to be undertaken if there is a “liquid market” for the project. If there is not a liquid market for the project then an expert valuation exercise is to be undertaken. In either case, the project company is paid the tender price or the price as valued by the expert less (i) the re-tendering or the re-valuation costs and (ii) the costs incurred by the public authority as a consequence of the default by the project company and the termination of the contract. However, there is no floor placed on the amount of compensation, and it is quite possible that a net payment from the project company to the public authority could result. When the provisions were first introduced by the UK government, there was a predictable outcry from lenders who noted the complexity of the clauses and that, at every turn, there was a possibility that disputes could arise, thereby delaying the eventual pay out. Of course, the main concern related to the fact that the provisions did not result in any certainty for the lenders that they would recover any outstanding amounts of their debt on a termination. However, as was the case with the DBFO road projects, competition for the projects resulted in the financing of projects where the re-tendering provisions were included in the project agreement. In the UK, they are now considered to be standard terms, not subject to any further material amendment.
As is the case in relation to DBFO road projects, there is a strong interplay between the determination of a liquid market and the attempts of the lenders to seek to transfer the project agreement to an alternative service provider under the terms of the direct agreement. Lenders were concerned that public authorities could seek to delay a payment of the “fair value” of the contract by commencing a fruitless re-tendering process following the lenders’ own inability to procure a replacement service provider under the terms of the direct agreement. Hence amendments were made to the procedure to provide that where the lenders have shown that there is no liquid market for the contract under the terms of the direct agreement (i.e. two or more willing buyers are not available), the authority is precluded from running its own re-tendering process and must proceed to the procedure providing for the determination of the fair value of the project.
(c) Infrastructure Projects in Africa
For projects in Africa, we have seen a range of approaches with no real “standard” or “industry” approach being adopted. Approaches do not seem to break down into sectors (as in the UK) and are developed on a project by project basis. This obviously has the disadvantage that “standard” positions are never developed and project participants are required to undertake detailed due diligence of the provisions for each project. In many circumstances, the choice of the termination compensation mechanism will be a function of the art of the possible. If a new sector (for example, the roads sector) is being opened up to the private sector, then to encourage lenders and sponsors to involve themselves in the initial round of projects, a more liberal approach to the issue might be adopted. Once the lending and developer community has seen a track record developing in the successful closing and operation of such projects, later tranches can then seek to take a more demanding approach. The question that must be faced by the public sector authorities is how far can they push the issue in the first round of projects? If they go too far, then they run the risk of presiding over a failed procedure with a consequent lack of credibility. If they are too lenient, then, inevitably, political consequences will arise.
By way of example, in the ports sector in Sub-Saharan Africa, we have seen termination compensation mechanisms for groundbreaking projects where the lenders are paid out by the public sector, no matter what the cause of the termination. This has enabled initial projects to be financed on the basis that lenders can take comfort in a quasi-sovereign covenant to pay out the debt should the concession agreement be terminated and has been justified on the basis of the “buy-back” and “unjust enrichment” arguments discussed above. However, these arguments are never entirely satisfactory, as it assumes that the disbursement of debt equates to the value of the assets created as a consequence of such disbursement. If a termination occurs during the construction phase, the argument becomes difficult to maintain as the value of the works to the public sector in their half completed state may well be close to zero if remediation costs are taken into account. Even if the engineer, procure and construction contract (pursuant to which the majority of the project debt will be paid) requires a milestone payment type structure, it is not uncommon for early milestones to be linked to design completion rather than completion of physical construction activities.
While the logic of the “buy-back” argument does not always hold up to detailed analysis, the approach can be justified on the need to ensure that projects get financed and are built and successfully operated. As stated above, lenders (particularly foreign lenders) and sponsors will only be able to accept more aggressive positions in relation to this issue where they can see an encouraging legal, political and regulatory framework which enables projects to stand or fall by their own commercial merits and a public sector partner that has the capacity and experience to form an effective partner in the development of the project.
(d) Power Projects in Sub-Saharan Africa
As stated above, there is no “accepted” or “standard” position in relation to the termination compensation issue in Sub-Saharan African countries as, in many cases, project documentation has been initiated from the private rather than the public sector resulting in a lack of central control and coordination of the issues. This has, historically, been true even in the case of the power sector, which is the most developed of the PPP markets in the region. In this sector, we have seen a range of approaches to the issue ranging from documentation requiring a full pay-out to project lenders on any circumstance of termination to documentation where there are no express provisions providing for any compensation to be paid where the power purchase agreement terminates due to the default of the project company.
An interesting approach we have recently seen is an obligation on the public sector partner to pay an amount as compensation linked to a percentage of the book value of the assets developed by the project company. The percentage is fixed by reference to the debt to equity ratio to be achieved in the financing (with a little headroom). The approach allows a relatively simple calculation to be undertaken at termination which ignores the actual value of the assets and encourages the lenders to maintain a debt to equity ratio in the project to ensure that they do not lose out on a termination. Of course, if termination occurs during the construction phase, difficulties will arise as to how the valuation of the assets is arrived at and the issues highlighted above with regard to milestone payment structures under EPC contracts remain. However, for a lender financing the project following the completion of the construction phase, i.e. when the value of the asset can be finally determined, the approach does give some degree of certainty as to the amount that will be payable on a termination while at the same time allowing the public sector to show that they are paying only a discounted price for the assets on the termination of the project. Equally, should termination arise as a consequence of a public sector default, the relative percentage of the value of the assets to be paid by the public sector can be increased to include some element of compensation for the equity.
The termination provisions for PPP projects in the UK have yet to be subjected to the scrutiny of the courts. This means that no-one can say for sure whether they will operate in the manner in which the lenders understood would be the case. However, they do at least have the benefit of being relatively standardised which limits the scope for argument. Now that lenders to the UK PPP market have become familiar with the provisions and have the added comfort afforded by a direct agreement, termination compensation is therefore no longer the hot topic it used to be. The same is not true for projects in Africa, where the ultimate backstop for lenders of the termination compensation regime is still seen as a crucial element for determining whether or not a project is financeable. As a final word, it is important to remember that simply having words in a contract stating that a certain amount will be paid on the termination of the contract is by no means the end of the story. The credit of the party undertaking to pay the compensation must also be assessed and, if necessary, mechanisms employed to ensure that the compensation will actually be paid should the unthinkable occur.