Comments on the Treasury Taskforce Guidance for standardisation of PFI contracts

Trevor Butcher comments on the Treasury Taskforce Guidance for Standardisation of PFI Contracts

The final version of the Treasury Taskforce Guidance on the Standardisation of PFI Contracts is expected to be published in late May. Throughout February and early March much effort went into reviewing the draft guidance of 29th January and comments were submitted to the Taskforce by numerous bodies representing the interested industry sectors. The Taskforce is in the process of reviewing and incorporating these comments.

Overall, there has been great support for the Guidance as a reference point, particularly in those PFI sectors where precedents for the allocation of key risks have not yet developed. The primary value of the Guidance, as the Taskforce recognise, will be as a tool to ensure that appropriate attention is focused on key contractual issues at an early stage: it is unlikely that we will see the wholesale adoption of the drafting from the Guidance. It remains to be seen how much influence the Guidance will have in those sectors where precedents are already firmly established and which are at odds with the Guidance. Initial experience based on the draft guidance indicates that all sides are finding it difficult to resist the temptation to ‘cherry-pick’ the elements which are most favourable to them.

Inevitably, each industry sector has its own particular concerns but the issue which appears to have attracted the greatest controversy is the Taskforce proposal relating to the compensation payable to the private sector following a termination of the PFI contract as a result of Project Co default. Such a termination could occur either where the lenders decide not to exercise step-in rights or following a step-in where the lenders subsequently step-out without having secured a novation to a substitute provider. In its submission to the Taskforce, the British Bankers’ Association states that the Taskforce’s proposals in this area “will result in a definite contraction of the market”.

Background

The controversy in this area is perhaps unsurprising given the wildly different solutions which have been agreed to date across the various industry sectors on the level of compensation which is payable in these circumstances. The following table shows some of these solutions:

Until publication of the draft guidance, a calculation based on assessing the net present value of future revenues and deducting certain public sector costs had been finding increasing favour.

Taskforce Proposals

The Taskforce has proposed that other than in special circumstances, compensation following Project Co default will be based on the market value of the unexpired term of the remainder of the contract. The special circumstances contemplated by the Guidance are where there are very limited numbers of possible suppliers and certain IT projects and in these circumstances the Taskforce accept that an NPV based calculation is unavoidable. In the Taskforce proposal, the market value will be determined by a re-tendering process where other private sector participants are invited to re-tender for the provision of the same services at the same unitary charge for the balance of the contract term. If the public sector opts not to re-tender, the valuation would be made by an expert using the same criteria. The termination compensation payment would then be equal to the capital value of the economically most advantageous tender - i.e. not necessarily the highest - minus the re-tendering costs and other costs incurred by the public sector in consequence of the default.

The Taskforce argues that this provides the correct balance between protecting the public sector interest and not over-penalising the private sector for Project Co default, i.e. it avoids the criticism that the public sector is making windfall gains in these default circumstances. The Taskforce also argues that this solution is much more likely to provide an incentive for lenders to step-in rather than relying upon a full payout . This is presumably on the basis that the Taskforce considers that in most circumstances a market value calculation will result in a figure which is less than the value of the outstanding debt. The point is also made that as compared to calculations using the outstanding senior debt as their starting point, this calculation is fairer to the equity providers and to projects with a high ratio of equity to debt.

Private Sector Response

The response of the BBA - which has the broad support of other parts of the private sector - has been highly critical of the Taskforce’s proposal based primarily on the following three concerns:

• that market value is only appropriate where there is a deep and liquid market for an asset, which cannot be said to be the case in many PFI sectors;
• that market value would be difficult if not impossible to determine at the point at which lenders are making a decision on whether or not to step-in; and
• that the market value calculation is likely to be significantly adversely affected by the fire-sale conditions in which it would be determined.

The BBA put forward a detailed counter-proposal for discussion which essentially involves reverting to a calculation based on the NPV of the future revenues. However, the NPV calculation would be based on a fully updated financial model which thus reflected the actual costs and actual performance at an agreed point prior to the default. Deductions would be made in respect of the costs necessary to bring the project back to fully performing status and any higher than originally anticipated future running costs. Each of these elements would either be agreed or determined by the contract disputes resolution procedure.

Sector
Compensation Construction Phase
Compensation Operating Phase

RoadsNoneNonePrisonsNone

Lesser of net present value of future cashflows and senior debt.HealthVarious based on outstanding senior debt completion costs.Lesser of net present value of future cashflows and senior debt.EducationFull Senior debtFull Senior debt

The Way Forward?

The Taskforce’s original objections to default termination compensation being based on an NPV calculation were that it was both complex (and hence difficult to negotiate) and unlikely to take full account of prior performance. They argued that it provided less incentive to the lenders to step-in and rescue an ailing project, presumably on the basis that they anticipated that the NPV of the future revenues would in most cases equal or exceed the outstanding senior debt.

Current speculation is that the Taskforce is unlikely to make any major shift away from the proposal contained within the draft guidance. Despite the strength of the objection from the BBA and others, it would appear that the Taskforce is likely to take the view that market value has been accepted in the past and that lenders are therefore likely to accept market value again in the future, provided that they are able to secure appropriate step-in rights through the direct agreement. Indeed, looking at sectors such as roads, much worse than market value has been accepted by lenders in the past.

The BBA counter-proposal however appears to provide a workable solution to this issue which deals with the primary Taskforce objection that insufficient consideration is given to actual past performance. It is a proposal which therefore merits serious consideration and it would be unfortunate if the overall value of the Taskforce Guidance were reduced by a failure to settle this issue.