Termination for the private party's default under a PPP - to pay or what to pay?

By Stuart Cosgriff and John Shirbin.

Key Points:
In negotiating a PPP contract both parties should carefully consider whether compensation will be payable by the Government to the private party in the circumstance of termination by the Government party for the default by the private party.

Contracts for PPP projects will usually require the private party to do two things:

1. finance and deliver an asset which, upon expiry of the term of the PPP contract, will be handed over to the Government at no cost; and
2. provide certain services related to that asset for the term of the PPP contract.

Government will usually reserve a right to terminate a PPP contract in circumstances where the private party is in default of its obligations with respect to the PPP project, in which case property in the asset will usually transfer to the Government upon termination.

The issue for both Governments and private parties alike is whether, in these circumstances, Governments should pay compensation to the private party as a consequence of the termination of the private party's rights under the PPP contract and the transfer of the asset to Government at a time earlier than the agreed expiry date of the term and, if so, how compensation should be calculated.

Termination of PPP

That there are a number of approaches to this issue is evidenced by the various 'guidance materials' which have been issued by Governments in respect of PPPs in recent years.

In particular, the New South Wales Government 'Working with Government Guidelines for Privately Financed Projects' issued in November 2001 states that:

"In the event of termination, compensation can be a complex issue. How parties are treated in this situation will necessarily vary between projects."

Common to every project, however, is the need to find the right balance around the reasonable objectives and interests of both parties in circumstances of termination for default. Government will want to maintain incentive upon the private party to perform the PPP contract and ensure that there is incentive for the private party's financiers to step in and rectify any failures by the private party to perform. Equally the private party and its financiers will be concerned that Government should not be entitled to take the benefit of a valuable asset, and terminate a valuable set of rights, in which the private party and its financiers have invested money without giving fair value for that asset and those rights.

How that balance is struck will depend upon the nature of the particular project.

Options available

In some cases, the balance may be struck by permitting the Government to terminate at no cost but not before allowing the private party long, and extendable, 'cure periods' (including additional cure periods for the private party's financiers) before events of default translate into an entitlement for the Government to terminate.

Alternatively, the balance may be struck by permitting the Government to terminate the contract and pay compensation to the private party for termination. In these cases, the calculation of compensation will need to have regard to the objectives of both parties and the 'balance' of incentives as it applies to the project will need to be taken into account.

In guidelines which have been issued recent by the Victorian and United Kingdom Governments, 'standard' approaches to the calculation of compensation for termination upon the default of the private party have been suggested. Both of these approaches require determination of a 'fair market value' of the unexpired portion of the contract.

Victorian Guidelines

On 8 October 2004, Partnerships Victoria issued for discussion a draft set of commercial principles which provide that on termination of the contract resulting from a default by the private party, Government will pay to the private party an amount equal to the fair market value of the net present value of the project as between a willing buyer and a willing seller (as calculated by an independent valuer).

The draft commercial principles require the independent valuer to assess the value of the project as if the willing buyer were bidding in a public tender for the right to design, construct, finance, maintain and operate the facility for the unexpired period of the contract term assuming that:

(a) the services are delivered in accordance with the performance standards set out in the contract; and

(b) the service fee provisions continue to apply as set out in the contract,

taking into account, if appropriate, any costs to be incurred to complete the asset and any rectification and reinstatement costs or other costs required to enable the delivery of the services for the unexpired term.

UK Guidelines

In April 2004, the United Kingdom Government issued 'Standardisation of PFI Contracts, Version 3'. Under the standardised PFI Contract, upon termination for default by the private party, the Government party:

• may re-tender the project, in which case the compensation payable will be determined based upon the highest price tendered for a conforming tender (with adjustments made for tender costs incurred by Government and amounts otherwise owing by the private party to Government); or
• if there is no "liquid market" for the project, or the Government elects not to re-tender the project, must pay compensation based upon an amount determined as the amount a third party would pay as the market value of the unexpired potion of the contract (with certain adjustments to it).

Inherent in the approach under both the Victorian and United Kingdom models is that the private party and its financiers take the risk that the fair market value of the project at the date of termination will be less than the amount they have invested in the project as at that date.

This should create incentive for the private party and the financiers to rectify defaults. The manner in which fair market value is determined, however, needs to be carefully thought through to ensure that the desired balance is achieved. As noted in the NSW guidelines, the parties should carefully consider the circumstances of each project in negotiating an appropriate termination and compensation regime.

Conclusion

In all PPP projects the issue of whether compensation should be paid upon termination of a PPP contract for the default of the private party and, if so, how that compensation should be paid should be carefully considered. The termination and compensation regime should be structured in a manner which is appropriate to each individual project and in such a way which provides incentives for both the private party and its financiers to take responsibility for the proper performance of the contract without enabling Government an opportunity to unfairly take the benefit of investment in the project.

For further information, please contact John Shirbin and Stuart Cosgriff.