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Structuring and Drafting the Tender and Contract

59.9 Early Termination Provisions [97]

Any contract may be terminated early for a number of reasons instead of continuing for its expected life. A typical classification of reasons for early termination is listed below.

 

Termination for convenience (or "unilateral termination”).

The government will always reserve the right to terminate the contract early, on the basis of public interest.

 

Termination for default by the public partner.

Some contracts specifically regulate the right of the private partner to terminate the contract for default by the public partner and claim for all costs incurred including opportunity costs. This right may be triggered if the procuring authority materially breaches its obligations (for example, there is an unusual and material delay in payments),

 

Termination for force majeure.

This may cover either the strict legal definition of force majeure (if there is one in the respective legislation), or other events or situations close to the general concept of force majeure, that is, events of extraordinary impact and/or of a clearly unforeseeable nature.

When the impact of a force majeure event is significant and has lasted for a defined period of time (typically 6 or 12 months), either party may terminate the contract unless specific agreement is reached.

 

Termination for default of the private partner.[98]

As noted, the procuring authority will have the right to terminate the contract when the private partner is in default. For instance, seriously breaching its essential obligations including persistent breaches — usually only after granting the private partner an opportunity to remedy and rectify the situation (this is regarded as good practice).

When the default is due to a lack of responsiveness of a sub-contractor or sub-contractor insolvency, it is good practice to allow the private partner to replace the sub-contractor.

The default may also be due to insolvency of the private partner. When the project company is not able to service its debt, the lenders may decide to accelerate the loan and the company will enter into insolvency. In such cases, rather than terminating the contract, it may be possible for the government to let the lenders and the company renegotiate the debt or let the lenders step in ( that is, take control of the project, allowing them to try to rectify the default, potentially by bringing in a different contractor to restore normal performance).

 

Defining how to calculate the compensation for early termination in the contract

It should be noted that in termination scenarios, it is not uncommon in civil law countries for the law to provide the right to the termination compensation and for the contract to refer to the respective law. In this context, the termination compensation should be described in clear terms in the contract.

It is not just good practice, but essential that the contract provides the private partner with significant protection (if not full protection) in the case of termination for convenience (unilateral termination), public partner default, and force majeure terminations. In addition, in the case of termination for private partner default, while the equity holders should bear a substantial burden of the default, the contract should still provide the right to receive compensation. This is to avoid the public partner getting a benefit beyond the implicit or explicit cost (damages and losses) suffered as a result of the default, which would also (perversely) incentivize the public partner to terminate the contract. Also, it must be remembered that a high degree of clarity and certain protection is paramount for the bankability of the project (Gide 2015).

The following describes the most relevant issues and considerations in defining the approach to calculating compensation sums in each scenario.

 

1) Termination for convenience: The contract should grant to the private partner the right to be compensated in full. It should recover all funds invested (outstanding equity which is the invested equity minus all distributions received to the date of termination), and be covered against the costs of breaking its contracts with third parties (that is, the amount should compensate for outstanding debt, financial debt breakage costs, other contract and sub-contract breakage costs, and demobilization costs). It should also include a sum to compensate for the opportunity costs of the equity investment.

The incorporation of the opportunity costs or the cost of capital for the private investors may be handled through different methods[99].

  • Including a payment in addition to the payments for all the factors described before. This allows the private partner to recover all equity invested plus a return that provides the equity IRR originally expected (to be calculated on the basis of the original financial base case agreed originally by the parties). This gives the private partner protection against being penalized through the termination for convenience payment for past poor performance[100]. However, it also involves a downside risk for the private partner because potential good or over-performance of the project is not rewarded.
  • The same as above, but providing a return (that is, obtaining equity IRR) equal to the expected IRR considering the current and projected performance of the project (calculated on the basis of an updated base case). Alternatively, it can involve basing the calculations on an estimation of the market value of the equity (the latter being a more complicated calculation) by means of discounting the projected cash flows or through other methods, for example, applying multiples from similar transactions). This would minimize the risk of the private partner being under-rewarded in over-performance situations, but it creates the unfair downside risk identified above in respect of past under-performance.

 

The payment on termination for public partner default is often calculated on the same basis.

 

2) Termination due to force majeure or similar situations: It is generally considered that the risk of force majeure should be shared to some extent between the two parties. It is regarded as good practice that the contract grants the private partner the right to recover all investments in full (that is, outstanding debt, all contract breakage costs, and outstanding equity so as to result in an IRR equal to zero). Some countries/contracts also recognize the right to a positive equity IRR at a pre-agreed rate, usually to obtain a close to 0 percent equity IRR in real terms (for example, a 2 percent equity IRR).

 

There are other methods to calculate the compensation.[101] The most important consideration is that the contract should clearly establish from the outset which method will be used to calculate the termination compensation and how this amount will be paid.

 

3) Termination by default of the private partner: The contract should grant to the private partner (or at least to the lenders) the right to receive a compensation sum for termination for default (the rationale being that the government will receive the asset in exchange for termination, and this should not be an undue benefit for the government).

The calculation of compensation for termination by default of the private partner is more controversial. Quite different approaches may be found in different countries.

  • Book value: In civil code countries, the most usual approximation is to calculate the compensation sum based on the net book value of the assets (see box 5.36).
  • Debt-based compensation: Consists of a payment equal to the outstanding senior debt, which may be necessary for EMDE countries to ensure bankability of the project. This method may reduce the incentive for lenders to oversee and ensure good performance of the project[102]. This may be corrected by including a “hair-cut” on the debt (establishing a percentage of the debt to be recovered, rather than granting the full recovery of all the debt) (Gide 2015). In any case, this approach may be unfair to the private partner, as the loss of the entire equity may exceed the potential value of damages and losses suffered by the public partner. Again, this creates a potential windfall for the government and a perverse incentive to terminate early.

An alternative approach, especially for EMDE countries wishing to ensure bankability, is a combination of these two methods (book value and debt-based compensation with a “hair cut”).

  • Market value/market sale: In other countries (typically common law countries), the government may decide to re-tender the contract, that is, to tender out the position of the equity owner and substitute the private partner. In this case, the compensation sum is the value of the project asset that the best value proposer will pay, which (after deductions of amounts owing to the government) is available to pay out the lenders with any surplus being available to the equity investors (“open-market sale”)[103]. This PPP Guide considers this a good practice: it introduces the possibility of avoiding contract cancellation by only tendering the remaining contract, and provides a framework for a fair compensation rather than a fixed methodology abstract from the reality of the project performance. It also allows the public partner to avoid the cash flow problem that arises if it is required to pay compensation from its own resources. However, in some default circumstances, there may not be any bidders for the re-tendered project, hence the contract must also include an alternative process under which the government will make a termination payment and the contract will come to an end. In addition, in the case of immature PPP markets in EMDE countries, it may be better to rely on simpler and more straight forward methods such as those described.

Alternatively, the procuring authority may agree with the lenders as to who will replace the defaulting partner (this is prohibited in some jurisdictions).

 

BOX 5.36: The Usual Compensation Method in Civil Code Countries in Cases of Termination for Default<br />
Upon termination for default of the private partner (as in any other scenario), the government will receive back the asset and will pay a price (the compensation sum).<br />
The common approach in civil code countries to calculate the compensation is to use the economic value of the asset (construction costs plus investments in renewal and major maintenance) minus depreciation of the asset (usually considering linear/constant depreciation during the term of the PPP contract). This is sometimes referred to as the as “net book value of the assets”. However, it is not necessarily coincident with the value as reflected in the private partner’s accounts, as this may vary significantly depending on the specific characteristics of the respective project contract.<br />
In other cases, the figure may be calculated on the basis of the whole investment that is, including those investments not strictly associated with the construction value but other applications of funds such as interest and development costs during construction (IDC).<br />
Under the net book value approach, the private partner will bear the cost of "damages and losses" suffered by the government, which will be deducted from the compensation sum.<br />
In this sense, it is good practice to set out in the contract the concepts on the basis of which damages and losses will be calculated, typically including direct costs incurred by the procuring authority to repair the asset (rectification costs), re-tendering costs, and contingencies regarding third party claims (for example, users), and so on.<br />
The government may also call on the performance guarantee which may either be considered as an advance to damages and losses or as an additional penalty to them.<br />

 

The provisions related to termination by default should be as clear and as objective as possible.

The contract should clearly state the following:

  • What constitutes an event of default that may entitle the procuring authority to terminate the contract. Materiality of the contract breaches that may constitute a default is paramount;
  • How the compensation sum will be calculated and when (how much time is allowed for the calculation). It is paramount to define in precise terms all the terms and concepts used in the calculation such as “distribution”, “IRR”, “Losses”, and “Senior Debt”, among others[104];
  • When the payment will be due and interest on the compensation payment if it is delayed or paid in instalments;
  • The right to offset or deduct any amount from the compensation sum and how this amount will be calculated (damages and losses);
  • How to deal with the seniority of lenders and subordinated lenders; and
  • Treatment of cash balances, insurance proceeds, and/or rights to claim against subcontractors.

 

[98] Some jurisdictions include termination for fraud as a specific category. In other cases, this is included in a private partner default subcategory.

[99] EPEC Guide to Guidance also explains the methods to determine the compensation sum in this scenario (page 41).

[100] As the contract is being terminated for convenience, it would be unfair for the private partner to be penalized through the early termination payments on the basis of the past performance of the project, as the termination prevents the private partner from rectifying its performance during the remaining original contract period.

[101] See Termination and Force Majeure Provisions in PPP Contracts (EPEC, 2013) page 21.

[102] The hair-cut may limit the positive effect on bankability or otherwise (if lenders request corporate guarantees to fill the gap of the compensation) be too onerous for the equity investor.

[103] When there is not enough liquidity or interest in the market to buy into the remaining life of the contract, the procuring authority will sometimes (typically in Australia and the UK) pay the lenders an estimated market value of the contract after deducting rectification costs. This is known as “fair value compensation” (EPEC). A deeper description of these processes may be found in “Termination for Default by the PPP Company” in the EPEC PPP Guide.

[104] Gide 2015 (commissioned by the World Bank) provides suggested definitions in its proposal of provisions for termination (page 31). Other recommendable standards may be found in the PPP manuals and guidelines referred to through this PPP Certification Guide, bearing in mind that any standard or recommended provision must be tailor made for the specific jurisdiction, and from there may require certain adaptation for specific projects.

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