The following guidance outlines the key issues that should be considered when managing insolvency and financial distress in relation to a Project Company or contractor.
It is important for the Procuring Authority to monitor the financial condition of the Project Company on an ongoing basis, as financial distress is not always easy to detect. Effective monitoring increases the likelihood of the Procuring Authority being alerted in sufficient time to address issues and ensure that public services are not affected. The Procuring Authority should also maintain clear communication lines with the Project Company to monitor key risks.
The Procuring Authority may require the Project Company’s financial statements to be submitted each quarter, with its audited financial statements submitted annually. These financial reporting requirements will be set out in the PPP contract. The Procuring Authority should carefully review these financial statements.
The Procuring Authority may also have the right to inspect the Project Company’s financial records by providing notice to the Project Company. If the Procuring Authority has concerns about financial performance, it should use this right to satisfy itself there are no significant issues.
Aside from financial statements, there are other early warnings of financial distress the Procuring Authority can look for.
The most obvious sign of financial difficulty is increasing delays in contractor payments, which indicate that the Project Company may have a cash flow problem. The following events are also notable:
Performance monitoring more broadly is detailed in Section 3.2 (Performance monitoring).
Where a key contractor faces financial distress, it has to potential to have a serious impact on the viability of the Project Company. This is particularly true in the construction phase where the key contractor or a related company is also a main equity investor and there are still obligations for equity contributions.
An independent certifier appointed by the parties will often report on the progress of the construction program, and on compliance with the output specifications during construction and sometimes operations. The Procuring Authority should use these reports to look out for early warning signs of insolvency. In addition to the events described above, the following events could be a sign of impending issues:
In some cases the financial distress of the contractor may be caused by the Project Company failing to make required payments due to a contractor. In these circumstances, the Procuring Authority may have a right to step in and remedy the payment default. The Procuring Authority should monitor this type of behaviour to ensure the Project Company is not increasing the project risks. Procuring Authority step-in rights are detailed in Chapter 7 (Default and termination).
This chapter details specific guidance according to whether the financial distress of the Project Company was caused by itself or a third party, or was contributed to by the Procuring Authority.
The Project Company’s financial distress may be caused by a range of issues, which can be directly related to the project or related to external events. For example:
Where the Project Company is facing financial distress, the first step for the Procuring Authority is to make an assessment of the underlying causes and extent of the issue. It will then need to assess how the risk of those underlying causes was allocated in the PPP contract to inform the approach that the Procuring Authority takes.
It may not always be clear how a risk was allocated and appropriate legal, financial and technical expertise should be involved to make informed decisions. For example, this can occur where the risk of latent ground conditions on a tunnel project is shared.
The cause of the Project Company’s financial distress may be due to the realisation of a risk that was clearly transferred to the Project Company under the PPP contract (e.g. because of lower than expected revenue on a project where the Project Company has taken demand risk), or due to the underperformance or mismanagement of the Project Company.
Where the Project Company is experiencing significant financial distress, the provision of services is put at a higher risk. Therefore, the Procuring Authority may need to consider the implications of the worst-case scenario of serious delay, insolvency and/or project termination against providing some form of compensation or relief. This is the case even where the risk was allocated to the Project Company.
The Procuring Authority should work with the Project Company to produce a recovery plan, where recovery is possible. This should be scrutinised by the Procuring Authority to assess its adequacy and if any further financing is required.
The Procuring Authority should also consider entering into a renegotiation of the PPP contract (or carrying out a rebalancing) to ease financial distress. This may include reducing the construction and/or operations obligations of the Project Company or extending the construction and/or operations phases. The approach to renegotiation is detailed in Chapter 4 (Renegotiation).
The Procuring Authority needs to calculate what the costs of the Project Company’s insolvency would be, both monetary and reputational – including the cost of terminating and retendering the project as necessary – and then determine the best course of action. Project Company insolvencies also attract negative publicity and may affect market appetite for taking over a failing project.
In some jurisdictions, the Procuring Authority can become liable to third parties if the insolvency cannot be avoided and third parties are ‘misguided’ to continue business with the Project Company due to measures taken by the Procuring Authority.
Proceeding with termination, and hence paying termination compensation, should be fully considered by the Procuring Authority, but only after all other avenues have been exhausted, and the equity investors and lenders are not prepared to contribute additional capital. In some instances, equity investors and/or lenders may be willing to invest further equity to salvage the project. Termination is detailed in Chapter 7 (Default and termination).
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.
Example – Cross border insolvency
The Project Company on a cross border rail project became insolvent due to significantly lower revenue than forecasted. In this case, the Procuring Authority stepped in to transfer ownership to an entity owned by the neighbouring countries to ensure continuity of service, with the majority of staff continuing on to the new operators.
Where the cause of the financial distress is due to a risk that was either retained by the Procuring Authority, or shared between the Project Company and Procuring Authority, it may be the actions or inactions of the Procuring Authority or a party related to it that is contributing to the financial distress.
For example, in the construction phase, the Procuring Authority should be aware that the Project Company may encounter additional liquidity issues where there is a ‘cash flow mismatch’ – for instance, when it has made a claim against the Procuring Authority for significant cost overruns but is still required to pay its contractors. In these circumstances, the Procuring Authority should work with the Project Company to process any claims and payments that are legitimately due to the Project Company as soon as possible, and may assist with a temporary short-term solution where full assessment of the underlying issue will take a long time.
It may also be in the Procuring Authority’s interests to assist the Project Company with a short-term solution where the Project Company’s cash flow difficulties are caused by a third party or other external event. Recent examples include the events of 9/11, which had a major impact on global air traffic, as did the eruption of the Eyjafjallajökull volcano in Iceland. Escalating tensions in certain areas of the world or airspace embargos could also create difficulties.
In some jurisdictions, applicable laws governing the provision of state aid may limit the assistance that government can give to private entities. Where the Procuring Authority decides to provide some sort of financing, subsidy or other benefit to the project, it must be aware of the applicable laws and procurement rules. Appropriate legal advice should be sought on the issue.
Example – Insurance proceeds delay
The Project Company may have short term cash flow issues due to delay in receiving insurance proceeds, which are available as a result of a natural disaster that has affected the project. Project Companies will typically have reserve accounts and/or liquidity facilities. However, they may still be inadequate. In these circumstances, the Procuring Authority can provide support by lending the Project Company money to get through short-term cash flow issues.
In case of insolvency, the Project Company will likely be exposed to insolvency processes and the impact of applicable rules and laws designed to protect the general body of creditors.
When faced with this situation, or a situation where the Project Company might be insolvent, detailed legal advice will be needed to understand the rights and obligations of all parties involved – the Procuring Authority, the Project Company and its directors and staff, the lenders, insolvency practitioners, the courts, the contractors and other relevant creditors.
Once the Project Company has become insolvent, the choices for the Procuring Authority become limited. Legal considerations are key to understanding the Procuring Authority’s options when the Project Company enters into insolvency. Insolvency laws differ widely in different jurisdictions. For example, in the common law jurisdictions (such as the UK and Australia), directors’ powers are immediately curtailed and an insolvency practitioner takes over the running of the company. The insolvency practitioner has the power to sell or restructure the company with little or no interference from the courts. In other civil jurisdictions, the processes can be heavily court-based, with sales and restructuring needing court approval and public auctions required. In any scenario, the Procuring Authority will be at the mercy of the insolvency practitioner and/or the courts. The lenders may also have additional step-in rights in these circumstances, which will add to the complexities.
When a Project Company is in financial difficulty, it is important that directors’ duties are well understood by the Procuring Authority, which will require specialised legal expertise. In most jurisdictions, directors’ duties with respect to the Project Company are completely separate from those of the construction company or any other equity investor – they must act in the best interests of the Project Company and not be conflicted by any other interests (e.g. in an equity investor, sponsor or contractor).
This is a challenge in itself, as the directors are typically selected by the equity investors or sponsors and will feel loyalty to their employer, which might not be aligned to the other stakeholders on the project. There are further challenges in several jurisdictions where directors can be held personally liable for certain company debts and, in some cases, have a fixed period to file for a company’s insolvency when there is evidence of it being insolvent.
These circumstances, which are specific to the project finance arrangements affecting Project Companies, add additional layers of complexity that need to be understood by the Procuring Authority when working with directors of the Project Company. Additional challenges will arise when the Procuring Authority has representatives on the board of directors of the Project Company.
View our list of previous questions and answers or submit a question to our PPP Contract Management team.