24 January 2019

PPP contract management – Is termination of a PPP contract dismissed too lightly?

24 January 2019

Early termination of a PPP contract can be an expensive process for all parties involved. Some typical scenarios that may lead to the termination of a PPP contract are:

  • default events (this could be the insolvency of a party or its material breach of the contract)
  • the impossibility for the parties to perform under the contract (for example, due to a prolonged force majeure event)
  • government voluntary termination due to public policy.

Termination can be particularly expensive for governments once construction is complete and operations have commenced, where the full costs of construction have been born by the project company. Where compensation due from the procuring authority is based on the repayment of some level of debt, this will be highest immediately after construction before any debt drawn down for construction has been repaid.  

Where a contract is terminated, possession of the public asset in question will often revert to the procuring authority. As a result, the procuring authority will be required to pay the private partner compensation agreed in the contract or prescribed by law, as the private partner will no longer have the project’s cash flows available to satisfy investors.

This compensation will often be payable even where the termination is the consequence of a project company default event.

Perhaps a more difficult time for termination is mid-way through construction, where the government procuring authority will find itself in the position of finding a new private partner to complete half-completed construction works, as well as potentially having to provide some compensation.

The termination of a PPP contract is not common. From an analysis of 198 PPP projects globally, 11 projects were terminated, indicating a prevalence of 5.5 per cent. Of the terminated projects, all were terminated by the procuring authority except for one, and they occurred mostly before the projects had become operational.

As well as the immediate financial implications, there are additional consequences of termination.

Reputational and market issues and ensuring uninterrupted continuation of services are some obvious considerations.

A procuring authority that changes its mind and terminates contracts frequently is less likely to attract future private investment and will increase the risk premiums charged by such investors.

Continuation of public services also needs to be ensured, so a plan needs to be in place to ensure that a government body or a new private partner is quickly set up to replace the terminated project company. This might be very difficult for more complex scopes of work or in markets with limited capacity.

Although the consequences of a termination can be severe for a procuring authority, it should still consider whether to terminate in an informed and well-considered manner.

Where a project company is obviously falling short of its obligations under a PPP contract, the best decision for a procuring authority may be to terminate the contract and replace the project company with one capable of delivering the project. For example, where the project company is unable to meet the performance standards agreed to in the PPP contract.

However, before doing this, the full cost of the termination should be considered, and an appropriate plan should be implemented to manage the transition.

Insolvency of a project company will often end in the termination of a PPP contract.

It might not be in the procuring authority’s interest to watch the project company fall into insolvency, even where the insolvency is a result of the eventuation of risks assumed by the project company. For example, where the project company has assumed demand risk in a road project and actual traffic does not meet the levels forecasted.

The project company in one of the case studies we developed in Brazil was facing financial difficulties, including lower than expected toll revenue, and challenges in raising the required debt finance.

The procuring authority was in the difficult position of considering extending the period in which investment could be completed, as well as whether to take additional 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.

The financial robustness of the project company’s key contractors should also be monitored, because the impact of an insolvency may have significant impacts on a project.

For example, where a project’s design and construction contractor falls into insolvency during construction, it will be very difficult to replace that contractor within the original budget and time constraints (even after utilising letters of credit and other forms of performance security). In such a situation, the procuring authority will likely have to work with the project company to agree a way forward.

A final word of caution described in the PPP Contract Management Tool is that termination and insolvencies are complex legal matters, and their full implications need to be considered in the context of legal advice.

Not only do contracts governing termination vary, but also underlying legal frameworks can affect insolvency and termination procedures, depending on the project’s location and contracting parties.         

The GI Hub’s full guidance on managing insolvencies and termination is available in Chapter 6 (Insolvency) and Chapter 7 (Default and termination) of the PPP Contract Management Tool. The data is available in Appendix A of the tool.   

The next blog will focus on the end of a PPP contract, handback of the project and ensuring governments receive the asset or service they’re expecting.

Please submit your questions and feedback on this blog and the PPP Contract Management Tool in the question and answers section of the tool’s website here.