Termination regime under the NSW Commercial Principles

By John Shirbin.

Key Points:
Although the final version of the NSW PPP Commercial Principles are similar to Victoria’s, there are key differences in the respective termination regimes.

In order for a PPP social infrastructure project to be bankable, a project agreement must deal comprehensively with the consequences of early termination. The release of the final version of the NSW Government’s "Working with Government: Risk Allocation and Commercial Principles" ("NSW Commercial Principles") reveals significant areas of commonality between NSW and Victoria on how they deal with the vexed issue of termination of a project agreement.

There are, however, a number of differences in the operation of the termination regimes in NSW when compared with Victoria. This article will highlight a number of those differences, as well as examine the method of calculation of termination payments provided for under the Victorian and NSW Commercial Principles[1].

Structure of the Termination regime

In general terms, Government may terminate a project agreement upon occurrence of a Termination Event or, in some cases, a Force Majeure Event. Government may also voluntarily terminate a project agreement (subject to payment of a termination payment), while the private party to a project agreement can terminate in the event of State Default.

Default Termination

Both Victoria and NSW share a general two tier termination regime in the event of default by the private party.

The first tier covers the more serious defaults which do not have cure rights, called Termination Events.

The second are those which do have cure rights are Events of Default. NSW also has a third tier of termination events called Persistent Breaches.

Differences in the Termination Event regimes

Termination Events are events which give rise to an immediate right for Government to terminate the Project Agreement – ie. there is no opportunity to cure. The list of Termination Events is largely consistent between the Victorian and NSW Commercial Principles. Examples of Termination Events are:

• abandonment or displaying an intention to abandon
• a breach of the change in ownership provisions
• completion of construction not occurring by a sunset date
• insolvency of the private party or of the construction contractor or principal service providers.

There are a few differences between NSW and Victoria as to what constitutes a Termination Event, for example:

• NSW has expanded the termination event for abandonment allowing it to be triggered where the private party displays an intention to wholly or substantially abandon the works or the provision of the services. This is to protect Government from threats by the private party not to continue to provide a service.
• NSW has extended the termination event for insolvency of the private party to include insolvency of the Construction Contractor or Operator or its guarantors. There is however a built-in 90 day cure period, allowing for the replacement of the insolvent entity.
• Victoria has, as a Termination Event, a claim under any performance or bond or parent company guarantee; NSW does not.

Differences in the Event of Default regime between NSW and Victoria

Typical Events of Default are:

• breach by the private party of obligation (other than a Key Performance Indicator ("KPI")), representation or warranty
• fraud, misleading or deceptive conduct
• cancellation of funding; and
• material service failures.

The NSW specification of Events of Default is slightly stricter than in Victoria:

• in NSW it will be an Event of Default if during the term, a representation or warranty given by the private party to Government proves to be untrue – unlike in Victoria, there is no requirement that the false representation or warranty have a material adverse effect on Government.
• NSW has taken the view if the issue is important enough to be representation or warranty in the Project Agreement, then it is important enough to require the private party to cure the breach.
• NSW makes it an Event of Default if there is fraud, misleading or deceptive conduct on behalf of the private party or its subcontractors in the performance of the project.
• NSW has a wider Event of Default for any breach of the project agreement and associated Government documents (other than breaches of KPIs) – unlike in Victoria, there is no requirement that the breach have a material adverse effect on Government or users of the facility. Also given the width of this Event of Default it is not necessary to include (as in Victoria) specific breaches such as a failure to effect insurances.
• Victoria makes the failure to commence works within a specified period following Financial Close an Event of Default – in NSW, this is a Termination Event to which cure rights do not attach.

Cure periods for an Event of Default

Under both the NSW and Victorian regimes, the cure period for an Event of Default will be agreed at the time and incorporated into a cure plan. The Victorian Commercial Principles provide a mechanism by which this cure period can be extended provided that the private party:

• provides Government with sufficient reasons for the extensions
• can satisfy Government that it will cure the default within the extended period; and
• can satisfy Government that it complied with and continues to comply with the cure plan.

NSW does not provide a mechanism for the extension of the cure periods. This can be explained by the different ways in which their respective project agreements provide for cure by financiers. In NSW, financiers have a separate and distinct cure period which operates outside of the project agreement.

Under the NSW model, where the Government has a right to terminate the project agreement and the relevant cure periods have elapsed, the financiers will then have a separate right to cure that default.

In Victoria, the rights to financiers to cure tend to co-exist with the cure rights in the Project Agreement – that is, if financiers want to cure they will need to step in and cure within the cure period provided in the Project Agreement itself. Therefore, it is more important to have a mechanism for extensions to the cure periods within the Victorian Project Agreements.

Persistent Breach regime

In NSW, a default may be subject to a Persistent Breach regime. There are two types of Persistent Breach outlined in the NSW Commercial Principles:

• first, a type or class of breach (other than a breach of a KPI) which occurs more than once during a specified period; or
• second, frequent breaches which substantially frustrate the objectives of the Project Agreement, affect the provision of the core services or adversely affect the interests of Government under the project agreement.

If another Persistent Breach occurs within the specified period, a Termination Event will result.

The purpose of a persistent breach regime is to pick up repeated Events of Default which may each be cured within the applicable cure period. It introduces a strong incentive for the private party to take appropriate steps to prevent them from occurring.

State Default

The final major difference in the termination regimes between the Victorian and NSW Commercial Principles is the introduction of a concept of State Default in NSW. In NSW, where:

• a material part of the assets or shares of the private party has been expropriated by a NSW authority; or
• NSW has failed to pay an amount above a specified threshold within 20 business days of a formal written demand by the
  private party; or
• a breach by Government which substantially frustrates the ability of the private party to perform for a continuous period
  of two months,
• the private party will have the opportunity to terminate the Project Agreement and receive a termination payment equal to the amount which would be received for a voluntary termination. However, the Government will have appropriate cure rights.

Calculating Termination Payments

Termination Payments based on private party default

At a high level both the Victorian and NSW Commercial Principles adopt a market value approach to calculating payments. It is felt, at least in NSW, that the market value approach represents a balance between protecting Government’s interest and not imposing unreasonable deductions on the private party for its default.

Generally the method by which the termination payment is calculated in both the Victorian and NSW Commercial Principles is similar. Called the Estimated Fair Value, it is:

• the net present value of the Service Payments less
• costs to provide the services going forward (including a reasonable risk assessment of cost overruns)
• costs of rectification
• any other costs associated with termination.

In both NSW and Victoria, where a liquid market exists, Government may tender out the unexpired term of the Project, as opposed to undertaking an Estimated Fair Value exercise. In such case the Termination Payment will be the capital sum paid by the successful tenderer less certain specified deductions. The rationale being that the best way to determine the market value of a project is to allow the market itself to determine that value, rather than try to approximate the value by using the calculation above.

What is a liquid market?

The Victorian Commercial Principles does not define a liquid market. In the past, NSW project documents have defined liquid market as there being at least two bidders (each capable of performing the project), in the market for PFP contracts or similar contracts for the provision of services, to ensure that the price that is likely to be achieved through a tender will be a suitable indicator of fair value.

This definition does not look at whether there are two bidders for the project in question, but generally two bidders who maybe capable of bidding for the project. The definition is drafted this way because:

• the test of whether a liquid market exists is only undertaken once, at the start; and
• the view is that if for a particular project there are no bidders, then it simply means that the market has valued the project as 0, not that there isn’t a liquid market.

Estimated Fair Value calculation

In calculating the Estimated Fair Value formula the cost of providing the services going forward is deducted. By doing this the termination payment takes into account scenarios where the termination event has occurred because the private party mis-priced or aggressively under-priced its bid.

By deducting the cost of rectification, the formula ties the amount of the Termination Payment to the condition of the asset, thereby arguably incentivising financiers to step in and rescue a project, as the ability of financiers to be repaid in full out of the Termination Payment may depend on the condition of the asset.

The New South Wales approach is to discount the Service Payments by the Base Case Weighted IRR[2] – what is essentially the weighted average cost of capital (WACC)[3].

The Victorian Commercial Principles adopts a different approach. It discounts the service payment by the higher of the base case equity return and the prevailing market rate of return. This means that its Termination Payment will be lower than under the NSW Commercial Principles as the equity return rate is greater than the weighted average cost of capital (because equity is more expensive).

It is likely that Victoria will re-think its position and adopt the NSW approach.

NSW prefers using the base case WACC as it will only use the estimated fair value approach where there is no liquid market, and in the absence of a liquid market it may be difficult to determine what the prevailing market rate of return is. From this calculation payment NSW Government will also deduct:

• any amounts owing by the private party to Government
• Government’s costs of retendering or calculating the estimated fair value
• any post-termination payment made by Government.

Calculating the Estimated Fair Value during the Construction Phase

The Victorian Commercial Principles applies the NPV approach to the Construction Phase too. NSW does not. During the Construction Phase the Termination Payment will be determined as the lower of:

• the design and construct costs incurred by the private party as at the termination date; and
• the design and construction costs forecast to be incurred from financial close (as set out in the Base Case and the Works Program) less the capital costs to be incurred by Government (including a reasonable estimate of cost overruns) from the Termination Date to ensure completion by the Target Completion Date.

The Net Present Value approach thus only applies in NSW during the Operations Phase. NSW has adopted this split approach because it was concerned that the NPV approach does not adequately take into account potential cost overruns during the construction phase and may, in some cases, lead to a windfall gain for the private party. Victoria may reconsider its position on this issue too.

Force Majeure Termination Payment

Generally the calculation of the Force Majeure (FM) Termination Payment Amount is the same between NSW and Victoria. Government will pay:

• the lower of the Senior Debt outstanding and the amount of Senior Debt which was forecast to be outstanding at the time under the Base Case financial model (including break costs etc); plus
• half of the equity as shown the in balance sheet of the private party at the time of termination, at par.

Victoria’s approach only differs in that it will not pay out any equity. As force majeure events are outside the control of both parties, the rationale is that both parties should share some of the pain. The Victorian Commercial Principles adopts the view that "sharing the pain" implies not paying out equity while NSW adopts the view that sharing the pain means the private party losing half of its equity (not all of the equity).

It should be noted that NSW has not adopted Victoria’s approach of calculating the termination payment on the basis of a private party default, if a private party default is subsisting at the time the project agreement is terminated for force majeure. It is unclear whether this will be acceptable to financiers; particularly as there is potential for their cure rights to be compromised if a force majeure termination event occurs before or during the financier’s step-in period.

Voluntary or State Default Termination Payment

Generally the calculation of Voluntary Termination Payment is the same under both the NSW and Victorian Commercial Principles. The Termination Payment will be equal to:

• the lower of the Senior Debt outstanding and the amount of Senior Debt which was forecast to be outstanding under the Base Case financial model (including finance break costs); plus an amount sufficient to provide an equity return equal to the base case equity return; plus
• finance break costs; plus
• any redundancy costs and amounts owing to subcontractors arising directly from the termination.

Again from the above amount Government will make similar deductions to those identified for default by the private party.

One key difference between the Victorian and NSW Commercial Principles is how they value the pay out of equity. NSW will value the payout of equity on the basis of the base case equity return while Victoria values it on the higher of the base case equity return or the market return. This means that in NSW, the private party gets all the upside of good performance, but none of the downside of bad performance.

Finally the Victorian Commercial Principles will, upon a Voluntary Termination, payout the greater of outstanding senior debt or the voluntary termination payment amount. NSW has not adopted this approach because it effectively means that the normal deductions NSW makes (for example, deductions for amounts owed by the private party to Government) cannot be set off against senior debt.

Thanks to Julian Gratiaen for his contribution to this article.

For further information, please contact John Shirbin.