(a)        Routes to termination

In a PPP project, the fundamental asset of the concessionaire is the concession agreement itself because without this the concessionaire has no inherent right to receive a revenue stream from the project. Typically, the underlying assets are the property of the government, and even where a lease is granted it is common for the lease to be co-terminous with the concession agreement. Therefore, on a termination of the concession agreement, for whatever reason, the concessionaire’s and the lenders’ investment will be at risk, except to the extent that the concession agreement provides for compensation. Even when compensation is payable, enforcement and recovery of these sums (which may be substantial) will be unlikely to be a straightforward process so it is important that the routes to termination are clear, fair and manageable. As a consequence, PPP contracts typically provide that termination may only occur on express grounds, such as specific events of default of each party, or extended no-fault events beyond the control of either party, such as force majeure events.

There will typically be more concessionaire default events than government default events as the concessionaire holds the majority of the obligations under the agreement. Typical default events would include:

• failing to complete construction within the agreed construction period plus a suitable longstop date (6-12 months being common);
• abandoning the works or services for a specific period of time;
• failing to comply with critical obligations, such as the provision of project insurance or performance security;
• persistently substandard operational performance beyond certain thresholds; and
• committing acts of bribery or corruption (and if carried out at sub-contract level, failing to remove the tainted sub-contractor from the transaction).

Some projects have many more default events and sometimes these are cast more loosely such as “material breach” by the concessionaire. The greater the number of events, and the more loosely they are drafted, the more difficult it is for the concessionaire to assess and manage its risk profile. This could affect the bankability assessment of the project during bid stage and delay financial close or even impact on the quality of bids received.

Government default events may be very few:

• failure to pay a specified amount beyond a specified period;
• interference that renders the project impossible (such as expropriation of assets); and
• a reorganization or transfer of responsibilities that affects the procuring government’s ability to meet its obligations.

As previously mentioned, force majeure events may lead to a right of termination if the event substantially prevents performance for a material amount of time such that the project has become uneconomic and the parties cannot agree an alternative way around it.

Other routes to termination may include passing an adverse change in law that renders the project impossible (typically treated as government default) or where the government retains the risk to terminate the project for public convenience (which is also treated as a government default for compensation purposes). Lack of available insurance (commonly referred to as “uninsurability”) can sometimes lead to the project being seen as impossible to run and may lead to a no-fault / force majeure termination.

(b)        Compensation on termination

On the termination of a PPP project, the concessionaire’s revenue stream comes to an end and the concessionaire, its shareholders, its lenders and its sub-contractors and suppliers will incur various losses unless otherwise compensated:

• the lenders will lose their unamortised debt and may also incur breakage costs as financial instruments such as interest rates and currency swaps are unwound;
• the equity investors will lose their unamortised equity, as well as the future return they expected to make if the project had gone to term;
• the concessionaire and its sub-contractors may have redundancy costs in respect of staff who can no longer be employed on the project; and
• the sub-contractors may have costs of demobilisation and of early termination of supply contracts, as well as the loss of profit they expected to make on their contracts.

What losses are compensated will depend on the respective fault of the parties.

In a government default termination (or a circumstance treated like a government default, such as termination for public convenience), the concessionaire would ideally expect full compensation for all such losses. It is very common for the heads of loss to be set out in the manner just described. Another approach that is seen is to compensate the concessionaire for the “fair value” of the project, i.e. what would an ideal purchaser pay to take over the concessionaire’s position in an open-market tender based on the state of the project prior to termination. This approach may be more appropriate where the concessionaire had accepted market risk because it will reflect the market’s expectation of the true profitability of the project going forward rather than the forecast profitability at the date of contract signature.

In a force majeure termination (or any other no-fault termination), the shareholders and lenders will typically expect to get back their basic investment, i.e. outstanding debt and equity. In the case of equity, credit will usually be given for equity distributions already received. In some jurisdictions, unavoidable redundancy costs and sub-contractor breakage costs may also be payable but the general principle is that no loss of future profit is payable. Another approach that is sometimes seen, alongside the “fair value” assessment described above, is for compensation to be based on “book value” of the assets, i.e. their depreciated cost over time in the books of the concessionaire. This may achieve a similar result but will need careful accountancy advice in the context of each project.

In a concessionaire default termination, the position is more complex. In a standard commercial contract it is normally the case that the defaulting party pays compensation. However, in a PPP contract this approach would leave the government with a windfall gain as it would be handed back the underlying asset for free without any debt attached. Typically, therefore, compensation is paid to the outgoing concessionaire to reflect the value transferred, but with a suitable adjustment to act as a disincentive.

In certain developed markets with a high project pipeline (such as the UK and Canada), where it is presumed that there is a liquid market for willing bidders to take over failed projects, the government may adopt a re-tender approach. The remainder of the concession contract is put out to tender (ignoring the default that led to termination) and the price paid by the highest bidder is then paid over by the government to the outgoing concessionaire. The theory is that the price paid should be a reflection of the net present value of the future income stream available under the project up to expiry, less a suitable allowance for rectification and uncertainty risk.

In other markets this approach has not been followed and would likely not be bankable. A very common approach is for the government to be obliged to pay out just the senior debt (or a percentage of senior debt), or for the government to assume the debt obligations directly. Unamortised equity would be lost and the concessionaire would be liable for any other breakage costs suffered by employees or the supply chain. The lenders will typically have first-ranking security over any such senior debt payment.

It is, perhaps surprisingly, common for infrastructure projects in emerging markets to be structured around a pay-out of 100% of senior debt in a concessionaire default scenario. With this being the case, it raises the question of whether the lenders are actually taking any project risk? In fact, lenders do not see the 100% underwrite by the government as a panacea. They know that it can be difficult and time-consuming to recover such debts from the government and there is a strong preference for the project not to reach such a point.

That said, there is a trend for infrastructure projects to be structured with a lower underwrite of senior debt, and many projects have closed with a floor value of 80%-95% of senior debt, and sometimes less. In these situations the lenders will be more at risk and can be expected to impose stricter terms on the concessionaire, the shareholders and the sub-contractors to ensure the success of the project.

(c)        Lenders’ direct agreement

Since a concessionaire default termination presents a risk for lenders, they will want to minimise the risk of this occurring. Lenders will typically insist on a direct agreement with the government to help in this regard.

The lenders’ key rights in a direct agreement will be as follows:

• an acknowledgement of the lenders’ security over the concessionaire’s contracts (ensuring no other party has competing rights);
• a right to be notified of any potential default and a “breathing space” before the government can exercise a right of termination (allowing the lenders to have some time to understand the issue and potentially take action before the termination arises);
• a right to appoint a representative to step in and manage the concessionaire’s affairs (to put the termination on hold while the lenders consider their long term options); and
• a right to substitute the concessionaire with a new project vehicle (if the lenders are able to find a suitable replacement contractor willing to take over the debt at the expense of the original equity).