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Structuring and Drafting the Tender and Contract

59.3 Contract Breaches, Penalty System, and Events of Default

Section 9.2 has shown how payments are linked to service performance through availability payment mechanisms, so that deductions or abatements are made from the payments commensurate with any failure to meet set service standards or target levels of service. The price paid is therefore adjusted to match the effective level of service rendered by the private partner so that the private partner suffers the financial consequences of under-performance.

 

Some or all of the events that result in a deduction may be regarded as contract breaches (see box 5.31), but they are not the only potential contract breaches which the private partner may incur. Also, there is a need to incentivize performance in projects other than through availability payments, and particularly in user-pays projects where there is not a direct payment from the government to the private partner that may be retained or deducted.

 

The contract establishes a number of obligations and conditions. These may be in the form of technical requirements (such as construction and time requirements during construction — for example, long stop dates for construction or interim milestone deadlines — and service requirements during operations), information or reporting requirements, legal requirements (that is, complying with legal provisions, such as labour laws), financial requirements ( for example, minimum equity investment), and other formal requirements.

When the private partner is not meeting a requirement or is failing to observe a provision of the contract, it is in breach of contract (contract breaches have to be distinguished from events of default, as not every breach will or should constitute an event of default). See box 5.31.

Breaches usually result in a penalty (unless it is already being addressed by the payment mechanism), with the penalty amount being commensurate with the importance of the obligation breached and the duration of the breach (for example, a delay in meeting a deadline). The scheme described in the contract that defines categories of breach and levels of penalty is called a penalty system[85]. This allows for the imposition of a financial consequence for breaching a provision of the contract, including, in the case of user-pays PPPs, failures to perform under the service requirements.

 

Some contracts adopt a two-stage system to apply penalties, using the performance points system explained below (see box 5.31). Each breach results in some points being accrued (the level of points depending on the relevance of the breach), and once the accrued points reach a certain threshold, the penalty is applied (and/or other remedial measures are taken that have financial consequences for the private partner, such as increased monitoring).

 

BOX 5.31: Contract Breaches versus Default Event

A breach of contract is a failure to observe a provision of the contract, and this may lead to penalties and events of default.

 

An event of default (with respect to or in the context of the PPP contract) is a breach of contract that relates to an obligation defined as essential in the contract, and which will entitle the procuring authority to terminate the contract.

Therefore, some contract breaches (when they are material breaches of the relevant obligation) will be defined as events of default, and all breaches when they accumulate to the point of being regarded as a persistent breach will also constitute an event of default.

 

It is typical for a penalty system (and/or a performance points system) to establish at least two categories (serious or major versus minor breaches). It is common for the contract to deem that any minor breach that is repeatedly committed constitutes a major breach for the purpose of applying a higher penalty (for example, a minor breach committed more than three times in a 12-month period is deemed to be a major breach). The contract should also define the “persistent breach concept” which may lead to more serious consequences. The penalty or Liquidated Damages (LDs) will be claimed against the private partner, deducted from government payments, or deducted from the performance guarantee/bond.

The contract should clearly stipulate the penalty system (and the performance points system), that is, which type of breaches will result in a penalty and/or in a point. It is good practice to list, define (that is, when a provision is considered to be breached), and classify the potential breaches of contract. See box 5.32.

Other good practice for contract breaches and penalty systems are as follows.

  • Except for very significant breaches, the government should be required to notify the private party that the breach event has occurred, and the private party should be provided with a grace period to rectify the breach.
  • Materiality should be recognized in the definition of the major breaches.
  • Many systems recognize the concepts of persistent breaches and persistent under-performance, which result in increasingly severe consequences.

Persistent breach means the accumulation of a significant number of breaches during a revolving period of time defined in the contract (for example, 10 minor breaches or 5 major breaches within a 24-month period[86], which may be counted directly or through the performance point system as described below. These situations may lead to a step up in penalties or to other decisions with financial or operational impacts on the private partner. For example, there may be an increase in quality audits at the expense of the Project Company, or the government may step-in and temporarily assume direct control of the Project Company (passing through to the private partner the costs of this intervention). Persistent breaches may also lead to contract default (see section 8.8).

BOX 5.32: Performance Point Systems and Persistent Breaches

The objective of a performance points system should be to provide an incentive for the private party to avoid contract breaches. It is used instead of direct penalties (that is, an immediate imposition of a financial penalty) to avoid persistent breaches by tracking them and how they are accumulated. It is useful to have trigger performance points where the direction of travel is identified. In this way, contract breach risks can be identified and action taken.

 

Going straight to a formal contract penalty process may be necessary in some cases but it should be recognized that both the breach and the way in which it is handled can affect relationships and future performance. The 'partnership' in a PPP is important and if every minor breach is treated formally and leads directly to penalties, the scope for innovation and risk taking is reduced. Therefore, introducing performance points as an intermediate step for penalties is good practice. The procuring authority needs to be clear about the nature of the relationship that it wants and how this is to be reflected in the breach and penalty context.

 

In addition to allowing for a two-stage approach to the imposition of penalties, performance points also provides for a clear handling of the risk of persistent breaches. Persistent breaches may indicate that the private partner is not competent, but may also indicate that the requirements of the contract are wrong or that the system of breach identification is too rigorous. Persistent breaches need to be investigated to identify the causes and whether they can be addressed.

The ultimate remedy against under-performance is to terminate the contract on the basis of default by the private partner. An event of default is a breach of contract that relates to an obligation considered essential in the contract (including persistent breaches), and which will entitle the procuring authority to terminate the contract.

It is good practice to require the breach to be material, and to provide the private partner with a period in which to rectify the default before the government becomes entitled to terminate the contract.

Typically under a termination by default, the private partner will lose the performance guarantee and will likely suffer additional financial harm depending on the method and approach that the contract stipulates for this event of early termination (see the discussion of early termination provisions in section 9.9 below).

BOX 5.33: Summary of Key Points about Contract Breaches, Penalties and Default

  • A breach of contract is a failure to observe a provision of the contract.
  • Contract breaches and/or lack of performance may result in the imposition of financial penalties or financial consequences; this is a way to incentivize and protect proper performance.
  • Failures to perform according to service performance requirements are handled primarily by deductions or abatements in the payment to the private partner in government-pays projects, but other contract breaches require explicit penalties (directly earned or by the accrual of performance points).
  • The same type of failures or service non-performance will usually be handled through penalties in user-pays.
  • The scheme by which breaches are defined and penalties identified is named the “penalty system”, noting that a breach should not be punished twice and therefore breaches that result in deductions in government-pays projects should not also earn an explicit penalty.
  • Performance points is a mechanism that allows the private partner to avoid immediate penalties. But, with increasing penalty amounts for repeated breaches, it is designed to control, in advance, any risk of a persistent breach situation.
  • Different degrees of persistency (different thresholds of performance points) may be designed to trigger escalating remedies: increased penalties, increased monitoring, “step in”, and ultimately an early termination event.
  • A private partner default may result in early termination. Such a default is a material breach of contract that relates to an obligation defined as essential in the contract. A material breach may result from persistent breaches of that obligation.

[85] In many common law countries, the term “penalty” has a specific legal meaning, referring to an amount of compensation specified in a contract that is out of proportion to the likely loss suffered by the other party. In these countries, different terminology such as “liquidated damages” is used.

[86] This example, as any other inside this PPP Guide, do not constitute a concrete recommendation, but have the value of a mere numerical example.

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