Revised Government guidance on PFI contracts

At the end of July, the Office of Government Commerce (OGC) published the Government's revised guidance on the Standardisation of PFI Contracts. The original guidance had been produced by the Treasury Task Force in 1999 and the revised document follows a lengthy period of consultation with both public and private sectors. The aim was to achieve consensus where appropriate but where this was not possible, the Guidance says that it "strikes a balance to help achieve a sensible commercial deal with all parties concerned". Whether or not this balance will be acceptable to the private sector on particular projects is, of course, another matter.

The revisions are intended to "clarify, enhance and re-balance the guidance in light of the public and private sectors' experience of the guidance over the past three years". There are many changes, but the principal ones are in the areas of service commencement, change in service, change in law, assignment, early termination, indemnities, insurance and the direct agreement. New sections have been added dealing with land and property interests, due diligence over sub-contracts and financing documents, commitment letters, alternatives to project finance, and refinancing. Sarah Thomas discusses some of the issues relating to indemnities and insurance in the next article in this edition of our Construction law bulletin.

The new guidance does not "seek to impose uniform treatment of all issues in all sectors" and says that private finance units and other relevant bodies will be reviewing with OGC and Partnerships UK their sector specific guidance to take account of the new guidance. The guidance recommends, however, that Authorities should review the changes made and consider whether to "align their approach with the principles described in" the new guidance. Where an Authority's advisers recommend a departure from the principles set out in the guidance, the Authority should require them to explain why such departure is necessary.

Refinancing

OGC expects Authorities and Contractors to use the new guidance on all transactions which have not reached the preferred bidder stage. But the amendments relating to refinancing should be introduced even for those projects where the preferred bidder has been appointed. This presumably reflects the significance which OGC attributes to the much stricter approach now taken to refinancing. The new guidance sets out the principles which should be followed and provides a draft clause.

A refinancing is defined as a transaction which has the effect of increasing or accelerating distributions to investors or of reducing their commitments to the project. The Authority's consent to any such refinancing is required and the benefits must be shared on a 50:50 basis to the extent they exceed the original base case IRR.

There are some exceptions. Thus, consent and sharing will not be required:

• for disposals of investments or commitments of junior capital which are equity or equivalent (although these may, of course, be subject to the change of control provisions in the contract)
• where the refinancing was included in the original financial model and taken into account in the calculation of the price
• where the project was originally undertaken on a corporate finance basis
• for gains derived from fixing interest rates at a lower rate than had been assumed at financial close, subject to certain conditions, including that the unitary charge has been determined by reference to market interest rates for the full term of the contract or
• where the gains result from changes in tax or accounting policies.

The Authority is given extensive audit rights so that it can satisfy itself whether a refinancing has occurred, whether consent is required, whether to give consent, and as to the calculation of the gain. The Authority should be reimbursed its costs of retaining advisers to review the refinancing proposals and the sharing of the gain is calculated after allowing for the costs incurred by both parties in relation to the refinancing.

Changes

The guidance now includes new paragraphs and drafting, reflecting current practice on many projects, enabling the Authority to give instructions and pay for "Small Works" during the service period i.e. after construction has been completed. "Small Works" are defined as works which have an individual cost not exceeding £1,000 (indexed) but which do not increase the likelihood of the service not complying with the performance regime or materially affect the Contractor’s ability to perform the contract. The Small Works are valued on the basis of pre-agreed labour rates (or if such rates are not applicable, at fair and reasonable rates), the cost of materials plus a percentage margin (suggested at 7.5%).

Another amendment makes it much clearer than before that the Authority should not, except in exceptional circumstances, reserve the right to change its construction requirements prior to service commencement. The list of circumstances which impose a limit upon the Authority proposing a change during the service period has also been considerably lengthened. However, drafting has been added entitling the Authority to require that any capital works involved in a change be put out to competitive tender if the estimated value of the work exceeds £100,000 (indexed).

Termination

In relation to termination for contractor default, the guidance now requires the parties to agree whether there is a liquid market for the contract at the time when the Authority issues its termination notice. If there is no liquid market the lenders will not exercise their step in rights under the direct agreement, the contract will terminate and the compensation on termination will be calculated on the basis of an "Estimated Fair Value". If there is a liquid market but the contract is nevertheless terminated (whether lenders have stepped in or not) then the Guidance still allows the Authority a right to choose the method of evaluating the compensation i.e. putting the contract out to tender or requiring an expert to decide the Estimated Fair Value of the contract, but restricts that right if it has been demonstrated during any step in period that there was in fact no liquid market.

New clauses have been added entitling the Contractor to appoint a "Tender Process Monitor" to monitor the tender process being managed by the Authority following termination for contractor default. The Monitor has no legal powers to influence the process, however.

Commitment letter

The guidance acknowledges that difficulties have been encountered because of protracted negotiations during the period between appointment of preferred bidder and financial close. It recommends that in order to try to overcome this problem, the draft contract should be issued with the ITN and, except in very limited circumstances, the bidder and its lenders should be asked to commit to the draft contractual terms at the time of the BAFO submission, or include in the submission an exhaustive list of suggested amendments. To this end, it advises Authorities to require each bidder’s BAFO submission to set out any suggested amendments to the contract with reasons, representations as to how well developed the sub-contracts and finance documents are and an estimate of the time it will take to reach financial close.

The guidance says that it is now market practice for Authorities to require a letter committing to the contract terms, in particular the payment mechanism, and setting out any outstanding issues which remain to be agreed. The submission of the commitment letter is a condition of appointment as preferred bidder. A draft of such a letter is included. It envisages that it will be signed by the bidder, the lenders and sub-contractors. The guidance's approach to the commitment letter, however, is perhaps more optimistic than is often achieved in practice and, if it was strictly followed, it would require bidders to commit more resource prior to BAFO than they are normally prepared to do.

Bid costs

The revised guidance does not give that much comfort to the private sector that bid costs will be reduced. Indeed, some changes introduced by the Guidance could increase the overall cost of bidding for PFI projects rather than reduce it.

Further work on the standardisation of drafting of contractual terms is needed. In many projects, the Authority's advisers are key to an efficient and economic competitive process. It is essential they have appropriate experience and resources.

There is still much that could be done in this respect.

For further information please contact Peter Long at [email protected] or on +44 (0)20 7367 2507.