The first step in managing the risk of Project Company default is for the Procuring Authority to be sufficiently aware of – and to monitor the Project Company for – potential defaults. The Procuring Authority should also monitor its own potential defaults; that topic is detailed below under guidance H. ‘Monitor and ensure compliance with the Procuring Authority’s obligations under the PPP contract and under the applicable laws’.

Such monitoring can include reviewing performance and financial reports, site inspections, notice requirements for potential defaults and other early indicators. In all of these examples the Procuring Authority can receive early warning of potential defaults. A good understanding of the PPP contract and the underlying legal system will help the Procuring Authority to be well aware of the potential implications of any such early warnings. Guidance on performance monitoring is detailed in Section 3.2 (Performance monitoring) and guidance on monitoring financial performance is detailed in Chapter 6 (Insolvency).

The Procuring Authority should not be caught unaware by a Project Company default as long as it appropriately monitors the performance and financial indicators of the Project Company. The Procuring Authority should carry out continual assessments of the likelihood of termination throughout the project. Following the relevant procedures will generally ensure advance warning is received by the Procuring Authority before a default occurs.

Once the relevant termination procedures have been followed under the PPP contract or under the legal framework, if a remedial action is not possible or was not followed by the Project Company, the Procuring Authority may then have the right to terminate the PPP contract. This will require the Procuring Authority to provide a termination notice. Such a step is not a minor decision and the government should ensure it has considered the full implications of issuing the termination notice. A decision to issue a termination notice should only be taken after consideration of the financial and non-financial consequences of such an action.

There are several key issues that should be considered:

• The circumstances in which the PPP contract may be terminated ahead of its scheduled expiry
  
  
• The compensation payment (if any) that must be made upon termination (either by the Procuring Authority to the Project Company or vice versa)
  
  
• The condition of the project when it is ‘handed back’ following termination, detailed in Section 3.1 (Managing Transitions)
  
  
• How to ensure service delivery remains uninterrupted during the termination process (detailed further below in this section)
  
  
• The reputational impacts of terminating a PPP contract, including the broader market implications, particularly where equity investors, lenders or contractors are adversely affected

Common termination compensation principles are detailed in Section 7.1 (Background). The compensation calculation may be complex to implement and the Procuring Authority should engage legal and financial advisors for this process. Because the two parties to the PPP contract have conflicting interests in the calculation of termination compensation, there is the potential for disputes to arise.

The Procuring Authority needs to carefully ensure that no unjust enrichment or other claim can be made against it where the project assets have been handed back and the Procuring Authority has not paid adequate compensation.

In a case of potential termination, the Procuring Authority may be required to go to the ministry of finance or central government to request funds to finance a termination compensation payment (particularly in a scenario where it is not retendering the project). A termination shortly after completion of construction is likely to involve higher compensation amounts, because the Project Company’s debt liabilities are typically the highest at this time. The bidders may have also required a government guarantee in order to enter into the PPP contract. In light of these challenges, the Procuring Authority should work with other relevant government agencies at an early stage to ensure there will be funds available to pay any termination compensation. Stakeholder engagement with other government agencies is detailed in Section 3.3 (Stakeholder management).   

From a legal perspective, the Procuring Authority should be aware that when a Project Company default arises it may have to use the right to terminate or lose it. For example, in several common law jurisdictions, a right to terminate may have to be exercised or be lost; it cannot be held over the Project Company in perpetuity. The more time that elapses after a default arises, the more likely it is that a court will consider that the Procuring Authority has elected to continue with the contract.

Example – Project Company difficulties in obtaining finance

The Project Company in one of the case studies in Brazil is facing financial difficulties with lower than expected toll revenue, and challenges in raising the required debt finance. The Procuring Authority is considering extending the period in which investment can be completed, as well as whether to take alternative steps such as:

• Terminating the PPP contract and retendering the project
  
  
• Replacing the equity investors with new equity investors capable of raising the required debt finance
  
  
• Requiring the existing equity investors to commit additional equity.

For more information, see the Brazil Toll Road Case Study.

Given the complexities of PPP contracts and termination regimes, and the potential implications related to a termination, the Procuring Authority should seek legal advice confirming that it does have the right to terminate the PPP contract. Any termination compensation payable to the Project Company may also depend on whether the Procuring Authority has properly terminated the PPP contract.

Although examples of some of the procedures the Procuring Authority may need to follow from an operational point of view are set out in this section, the detailed requirements will be specific to a given PPP contract and the underlying legal framework and will need to be followed diligently.

Once a termination notice is issued by the Procuring Authority, it may not be capable of being recalled. In such circumstances - if it is found that the Procuring Authority did not have a valid right of termination - the PPP contract cannot be resurrected. Rather, there would be a potential claim against the Procuring Authority for unjust termination of the contract, and a starting point for termination compensation would be at a much higher level.

In several jurisdictions a termination notice must be preceded by a court proceeding, thus assuring the right of the Project Company to defend the termination. Given the complexities around PPP contracts and termination regimes and the potential implications of getting it wrong, it may still be advisable for the Procuring Authority to first seek a formal declaration that it has the right to terminate even in jurisdictions where a court proceeding is not strictly required.

There are additional restrictions in some jurisdictions which mean that a PPP contract cannot be terminated until the Procuring Authority takes over the project or a new Project Company is awarded a contract to take over the project. This stems from principles of continuity and adaptability of public services, under which public services must be guaranteed by the Procuring Authority and must not be threatened by action or inaction of the relevant private partner.

Example – Inability to meet specifications

A specific case of default can occur where the Project Company has not been able to meet the specifications agreed in the PPP contract. This is important for projects where there is the use of a new technology which is vital to service provision but the performance of which is not yet fully known (e.g. a waste sorting facility on a waste project). Certain waste projects are encountering this challenge and there is a possibility that the Project Company will simply not be able to provide the service it is required to.

For example, if the winning bidder has ‘oversold’ its solution and created a specification that no one could obtain with current technology, then from a legal perspective, an impossibility to meet project specifications creates a difficult legal position.  Existing standard form PPP contracts are not designed to address such a situation.

A termination should be properly planned before the termination notice is delivered. Once the Procuring Authority has followed the required processes and obtained appropriate legal advice, the Procuring Authority needs to ensure that the implications of issuing the termination notice are clearly understood and the continuity of service for the users will be ensured, including engaging appropriate support to manage the process. Terminating a PPP contract has the potential to interrupt services and for the Procuring Authority to incur significant costs.

The Procuring Authority will have two options in case of a termination. The appropriate option should be decided well before the termination of the PPP contract such that the Procuring Authority can plan the transition and avoid the risk of suffering disruption or interruption in service delivery.

1. Retendering
   

   The Procuring Authority is entitled to retender the project to a new Project Company, provided there is market appetite. The amount received from the winning bidder in the retendering may be applied towards paying termination compensation to the original Project Company. The Procuring Authority will have to comply with the relevant procurement laws in that jurisdiction.

2. No retendering
   
   Where the Procuring Authority decides not to retender the project and to take over the asset itself, it will typically still be required to appoint contractors to deliver the services required under the original PPP contract. The short term financial implication of this option will be more severe for the Procuring Authority as it will not receive an amount from the new Project Company.

The method of transferring the project assets, and whether to transfer them straight to the winning bidder (without being handed back to the Procuring Authority), should also be addressed at an early stage and there may be specific procedures required by the underlying legal system.

Example – Cross-border rail termination

The PPP contract on a cross-border high speed rail project was terminated by the two national Procuring Authorities after the insolvency of the Project Company. A new operator joint venture between the two national governments was set up to continue operations.

Where the PPP contract is terminated and retendered, the choice of the substitute Project Company will require the Procuring Authority’s approval.

The Procuring Authority must determine that the new Project Company is eligible, including that it complies with the PPP contract, any direct agreement, the applicable laws, regulations and standards; and that it has the requisite track record and reputation, technical expertise and financial resources. For example, the relevant procurement regulations that covered the procurement process prior to financial close may become relevant again, including being subject to retendering requirements.

A range of contingent liabilities will also typically exist for the Procuring Authority depending on what support and guarantee mechanisms are in place, such as any government guarantees of payment obligations and the agreed risk allocation. These contingent liabilities must be considered, as they may be affected by the structure of the new Project Company (including the new Project Company’s debt financing arrangements).

The Procuring Authority may also need to negotiate the duration of any services suspension while a transfer is taking place, the extent of a ‘temporary amnesty’ or ‘wipe clean’ mechanism related to any existing payment deductions to be given to the substitute Project Company, criteria for the replacement of any contractors, and a detailed remedial plan for resolving the overall issues.

If termination becomes a real possibility, the Procuring Authority should communicate with lenders at an early stage, while being careful to comply with all applicable laws. For example, giving preferential treatment to a particular lender or class of creditors may breach insolvency laws.

Given the seriousness of a default and potential termination, lenders will closely monitor any event of default. This is broadly positive for the Procuring Authority, as the lenders are incentivised to intervene and help the project achieve its goals. Both the lenders and the Procuring Authority have strong drivers and incentives to want the service provided to the end-user to not deteriorate.

The research highlighted that sometimes the relationship between the Procuring Authority and the lenders was sometimes almost non-existent at the earlier stages of Project Company breaches of contract. The Procuring Authority may therefore not have much visibility of the lenders’ involvement and actions at these stages.

In addition, it is common for the lenders to want a chance to step in to cure a Project Company breach of contract, as detailed in Chapter 6 (Insolvency).  In these circumstances, there is typically a direct agreement entered into between the Procuring Authority, the Project Company and the lenders.  Under this arrangement, the Procuring Authority will need to permit the lenders to take control of the PPP project under the step-in provisions, give the lenders a chance to remedy the breach, and not terminate the PPP contract until the lenders have had the chance to exercise their step-in rights. The direct agreement will typically set out a timeframe during which the lenders will have to cure the contract breach and the Procuring Authority may be required to go through an additional round of remediation plans with the lenders.

Lender step-in is quite rare in practice because of the lenders’ reluctance to take over the role of the Project Company and the complexities associated with the execution of these provisions. In Brazil, lenders are not entitled to step-in to the project to take control without a prior authorisation by the Procuring Authority. In the study no examples of lender step-in were encountered.

The Procuring Authority will typically have the right to step in and take action in order to undertake certain activities of the Project Company when the Project Company is failing to meet its obligations under the PPP contract. The reasons for step-in may be defined and are typically based on protecting the public interest. Procuring Authority step-in is not a common event. In the study only one clear example of Procuring Authority step-in was encountered, where an environmental incident occurred and the Procuring Authority stepped in to address the situation.

The Procuring Authority may have the right to step in to address a breach of contract before it becomes a Project Company default. This may affect any right to terminate the PPP contract that the Procuring Authority would otherwise have had.

The Procuring Authority should step in when it believes it needs to take action that requires an urgent response, such as where there is a serious risk to the health and safety of persons, property, or to the environment. It may also be required to step in to discharge a statutory duty. A Procuring Authority may decide to step in in situations where the Project Company has failed to meet its obligations. However, step-in can also occur where the Project Company is not in breach, but there is some other justifiable reason.

While step-in is clearly justified for certain events (e.g. where there is an overriding public service or national interest issue) there is an argument that for less serious issues the Procuring Authority should not have the right to step-in; it should apply the payment deductions and ultimately terminate for default if it is not satisfied with performance.

Where the Procuring Authority does decide to step in, it should ensure it provides sufficient notice of its step-in, as well as its step-out, should it decide that its actions are no longer required. As the Procuring Authority will be taking over responsibility of certain functions, it must be aware of the capacity and expertise that will be required by these activities.

In some jurisdictions the approach is that even where a step-in is motivated by a Project Company default, the Project Company should be adequately compensated in terms of its payment, save only for the costs incurred in stepping in and rectifying the issue in question. The logic in this is that, if the Procuring Authority can both step in and apply payment deductions for non-performance, the Project Company is no longer in control of its own destiny and is at the mercy of the Procuring Authority acting swiftly and reasonably.

It is important for the Procuring Authority to ensure that it carefully manages any potential default of its own causing, and does not find itself in a situation where it could be assessed to have committed a default in any way. Termination due to a Procuring Authority default, due to the actions of another government agency or due to the Procuring Authority’s voluntary election to terminate in the absence of default, are typically the most costly to the Procuring Authority.

The Procuring Authority must monitor and assess the situation as soon as it becomes aware of any potential default which would trigger a termination right for the Project Company. The Procuring Authority obligations under a PPP contract (with which failure to comply may lead to a default) are principally payment obligations and approval rights, rather than detailed performance obligations. However, in some instances where the Procuring Authority retains land acquisition or permitting risk, any failure to fulfil these obligations is likely to render the Project Company unable to meet its obligations and may subsequently lead to a default. The Procuring Authority may also have positive obligations to complete interfacing infrastructure.

The occurrence of a Procuring Authority default, whether notified by the Project Company or not, must trigger an alarm at the highest levels of the Procuring Authority together with immediate action to avoid termination. The Procuring Authority contract management team needs to be well aware of the agreed defaults (whether provided for in the PPP contract, under the applicable laws, or another agreement) such that it can act before the Project Company serves the Procuring Authority with a termination notice.

Once the Project Company has served a default notice, the Procuring Authority will typically be given a cure period (that is, time in which to rectify the default, where possible) before contract termination can occur. This gives the Procuring Authority a final chance to avoid termination and its associated consequences.

All effort and resources should be applied to carry out whatever mitigation is required, although that mitigation should have started well before notice was served by the Project Company.

Another approach when a Procuring Authority default is inevitable is to work with the Project Company to make the arrangement work through a renegotiation process.  Specific guidance on renegotiation is detailed in Chapter 4 (Renegotiation).

Example – Interfacing works

At the time of signing the PPP contract for the Intercity Express Programme project in the UK, the parties agreed that the Procuring Authority should retain the risk for delays caused by delays in Network Rail delivering interfacing works. Network Rail was classified as an arm’s length public body in 2014 and is a separate body to the Procuring Authority. Delay and cost caused by Network Rail’s delay in delivering interfacing electrification works did cause delay and cost to the Project Company. This demonstrates the impact third parties can have on an overall program of works.

For more information, see the Intercity Express Programme Case Study.

Example – Renegotiation

The lenders on the Segarra Garrigues Irrigation System project in Spain exercised their rights to stop providing debt to the Project Company when the credit rating of the Procuring Authority dropped below a defined level. This default caused delays to the project and forced the regional government to renegotiate the financing for the project as well as the PPP contract.

For more information, see the Segarra Garrigues Irrigation System Case Study.

A default with respect to a key contractor under a relevant subcontract (such as a construction contractor default under a construction contract) can present a significant risk to the Procuring Authority. For example, it may lead to a Project Company default under the PPP contract. It is important for the Procuring Authority to monitor these risks, particularly during construction. Termination of a construction contract during construction significantly increases the risk of a project.

The Procuring Authority should identify the risk of potential key contractor default as early as possible and monitor how the risk evolves. The risk register should provide a continuous assessment of the termination risk in terms of its likelihood, severity and potential mitigation measures. For example, the Procuring Authority can monitor the construction contractor’s publicly available financial indicators.

The Project Company will typically require key contractors to provide a security package (that is, performance guarantees and/or appropriate agreed compensation, etc.) to mitigate the implications of the termination of a key contract.

The PPP contract may stipulate, in the case of termination of a key contract, that the replacement contractor will be required to be reputable and financially robust, have the requisite resources and experience to complete the works, and willing to agree to a construction contract on similar terms to the original key contract. These attributes will be important to the Procuring Authority to minimise the risk of poor performance by the key contractor.

The Project Company will seek to replace the key contractor as soon as possible to reduce the risk of a default event under the PPP contract, and to minimise any financial implications. This could lead to a choice of replacement contractor that does not meet the requirements of the Procuring Authority, and this process should therefore be managed closely by the Procuring Authority. Working with the Project Company to agree to the appointment of a new contractor will typically be in the best interests of the project and the Procuring Authority.

The ease of replacing a contractor will depend on a number of factors, including:

• The complexity of the construction or operations – for large, complex projects it will be harder to find a suitable replacement
  
  
• The market in which the key contractor is required to operate and how many equivalent contractors in that market have capacity
  
  
• the stage during which the insolvency has occurred: During the early stages of the construction phase, it may be easier to find a replacement; Conversely, during the operations phase, it may be easier to find a replacement if operations have already been running for a period of time

If the relevant contract has been signed by a joint venture of contractors, tied under joint and several liability, then the other member(s) of the joint venture will take over the obligations of the insolvent contractor. This may make the situation easier, and there is the potential for this problem to be resolved with little input from the Procuring Authority.

Example – Construction long stop dates

It is common that a failure by the construction contractor to meet a long-stop date agreed in the construction contract between the Project Company and the construction contractor will constitute a construction contractor default under the construction contract and entitle the Project Company to terminate that construction contract. The long-stop date signifies the final date that the construction contractor can complete the construction works before a default occurs. The Project Company will aim to ensure a construction contract default will not immediately trigger a Project Company default under the PPP contract and will have a corresponding longer long-stop date under the PPP contract to provide time for the Project Company to replace the original construction contractor and complete the construction works before a Project Company default occurs.

Although the long-stop dates may be staggered in this way, the buffer periods may not be long enough to allow the Project Company to terminate and appoint a new contractor and complete the works before the Project Company default occurs. Instead, the buffer period provides useful breathing space for the Procuring Authority to open up dialogue with the Project Company to decide the approach to be taken that will be in the best interests of the project. Note, such discussions will require legal advice, particularly where termination rights are being waived.

Example – Insolvent construction contractor

One of the members of the construction joint venture on a project in Europe became insolvent. The remaining members of the joint venture took over the work, which the Procuring Authority monitored carefully.