This Practice Note, produced by Mathias Cheung in partnership with LexisNexis, considers insolvency aspects of PFI/PFI2 projects including contractual provisions such as step-in rights, enforcement of security, insolvency of Project Co and protective measures to counter insolvency risks.
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Reprinted with permission of LexisNexis, all rights reserved.
Guide to insolvency in PFI/PF2 projects
This Practice Note is a guide to insolvency in PFI/PF2 projects. The aim of this practice note is to provide restructuring and insolvency practitioners with an overview of the relevant contractual provisions, restructuring options and potential measures to protect a client’s position.
What are PFI/PF2 projects?
The Private Finance Initiative (PFI) is a public private partnership (PPP) model, the purpose of which is to procure and deliver a variety of public infrastructure and services, including schools, hospitals, prisons, railway links, roads and social housing.
A PFI project is typically funded by private sector lenders, with private sector contractors taking on the burden and risk of the design, construction and/or day-to-day operations. Each PFI project is usually a long-term arrangement which lasts for 25–30 years.
Private Finance 2 (PF2) was introduced by the government in December 2012, with a view to increasing the sources of equity and debt finance, increasing transparency, and reducing the cost of the procurement process. In particular, the government often acts as a minority equity investor in PF2 projects.
The parties involved in a PFI/PF2 project depends on the type of infrastructure/service being procured and the funding arrangements in each project. For a more detailed discussion of the parties typically involved in a PFI/PF2 project, see Practice Notes: Key parties in a PFI/PF2 project and PFI structure—diagram.
For the purposes of this practice note, the key parties and documents include:
- the Project Agreement between the Authority/Trust and a special purpose vehicle (commonly known as Project Co), the latter of which may be a joint venture company.
- the Construction/Design and Construction Contract between Project Co and the construction contractor (Construction Contractor)
- the Facilities Management (FM) Contract between Project Co and the FM contractor (FM Contractor)
- the Collateral Warranties/Direct Agreements between the Authority/Trust and the Construction/FM Contractors, and between Project Co and the suppliers and sub-contractors engaged by the Construction/FM Contractors
- the Finance Documents (eg loan agreements, security agreements, funders direct agreements) between the funder(s), Project Co and/or the Authority/Trust
Further details of the key documents in a PFI/PF2 project are set out in Practice Note: Key documents in a PFI/PF2 project.
Political context of PFI/PF2 insolvency
Although insolvency in PFI projects is not a new phenomenon, the collapse of Carillion in January 2018 has thrown the political complications of such insolvency events into sharp relief. In light of the nature of PFI/PF2 projects, it is common to have extensive negotiations with the Authority/Trust and the government both before and after an insolvency event.
To take a concrete example, Carillion engaged in high-level discussions with its lenders and the government to negotiate a restructuring of its debts and a potential bail-out, but the government’s decision not to bail out Carillion made its collapse inevitable. This gave the government a high degree of control over the liquidation through the appointment of an Official Receiver, and the government was also able to transfer numerous contracts back into public ownership. For more discussion on the insolvency of Carillion, see News Analysis: Carillion crisis—restructuring and inevitable insolvency.
Therefore, the success of any restructuring exercise often requires some form of political compromise, taking into account public perception, public interest in the continuing delivery of the infrastructure or services, and the impact of the restructuring exercise on the continuing affordability of the project. This provides essential context to the issues arising from insolvency and restructuring in PFI/PF2 projects.
Navigating PFI/PF2 insolvency—steps and provisions
Perhaps the most daunting task in the face of insolvency in a PFI/PF2 project is getting to grips with the numerous agreements and documents, which necessarily inform the steps to take in any intended restructuring exercise. The terms of the documentation will be key in determining the options your client may have and form the basis of any contingency planning around the potential insolvency of a party to the PFI/PFI2 project.
In summary, the key provisions and steps which often come into play in the face of insolvency include the following:
- Acceleration under the loan agreement between Project Co and the lenders
- Enforcement of security provided by Project Co and/or contractors under the respective security agreements
- Termination of Project Co and/or the contractors
- Step-in and novation under the funders direct agreements between the lenders on the one hand, and the Authority/Trust, Project Co and/or contractors on the other
(i) Acceleration provisions under the Loan Agreement
Insolvency and insolvency-related proceedings in respect of Project Co or one of the Contractors are usually defined as an ‘Event of Default’ under the loan agreement.
In the event of such occurrences, the loan agreement typically provides for the right of the lenders (collectively, and often through a facility agent) to take a range of actions to protect the interests of the lenders, including:
- cancelling the total lending commitments of the lenders under the finance documents
- giving an acceleration notice rendering all or part of any outstanding amounts under the finance documents immediately due and payable or payable on demand
- instructing the security agent to take any steps permitted under the respective security agreements, including enforcement of the security provided by the party becoming insolvent
Given the potentially draconian effect of the steps outlined above, in the case of a contractor becoming insolvent, the loan agreement usually allows a grace period for the Project Co to replace the Contractor on the same terms, or at least submit a plan to rectify the situation. The expiry of such a grace period is usually a condition precedent for the lenders to take any action under the acceleration provisions.
Depending on the specific loan agreement in question, the facility agent may have the discretion to exercise the powers provided by the acceleration provisions, and will usually be required to do so if instructed by a majority of the lenders. Individual lenders do not usually have the right to take independent action.
(ii) Enforcement of security under the security agreements
The enforcement of the security provided by Project Co and/or the Contractors is governed by the express terms of the relevant security agreement. The security often becomes immediately enforceable by virtue of a notice given under the acceleration provisions of the loan agreement (as outlined above), and is directly triggered by an ‘Event of Default’ under the Loan Agreement.
Once the security becomes enforceable, the security agent is usually given an absolute discretion to enforce all or any part of the security or express instructions from the majority of lenders.
The options available to the security agent after the security becomes enforceable depend on the specific terms of the security agreement in question. The security agent is usually entitled to exercise any powers of sale and leasing conferred by law, take steps to protect and maintain the security asset, and appoint a receiver to perform these functions.
The proceeds from the enforcement of the security must usually be applied in accordance with the express terms of a security trust and intercreditor deed. For further reading, see Practice Notes: Enforcement—debentures and floating charges and Intercreditor agreements for R&I lawyers.
(iii) Termination of Project Co or Contractors
One of the natural consequences of the insolvency of Project Co is the termination of the Project Agreement, as Project Co’s insolvency is almost invariably an ‘Event of Default’ which entitles the Authority/Trust to exercise a contractual right of termination. The Construction and FM Contractors would usually have similar rights of termination under the Construction and FM Contracts respectively if Project Co becomes insolvent.
The Authority/Trust and Construction/FM Contractors are normally required to give advance notice to the Lenders under the funders direct agreement prior to any proposed termination. This is to afford the lenders a proper opportunity to consider exercising its step-in and novation rights, as will be discussed in the next sub-section below.
In a similar vein, the insolvency of a Construction or FM Contractor is almost always an ‘Event of Default’ under the relevant Construction Contract or FM Contract, such that Project Co would be entitled to exercise a contractual right of termination upon obtaining prior written consent from the Authority/Trust. In this case, it would be necessary to procure a substitute Construction/FM Contractor, or transfer the FM services back into public ownership.
For more details on termination, see Practice Note: Termination of PFI/PF2 contracts.
(iv) Step-in and novation under Funders Direct Agreements
Step-in and novation rights are standard provisions which exist in almost every PFI/PF2 project, and they provide the lenders with an important means by which to protect their financial interests. As with the other rights and powers discussed above, the scope of the lenders’ step-in and novation rights depends on the express terms of the funders direct agreement in question.
In a typical funders direct agreement, the lenders are entitled to notify the Authority/Trust or the relevant Construction/FM Contractor that an appointed representative would assume Project Co’s rights and liabilities under the Project Agreement or the Construction/FM Contract respectively.
A step-in notice usually has to be given when an ‘Event of Default’ is subsisting, or within what is known as the ‘Required Period’ (ie the period of advance notice to be given by the Authority/Trust and the relevant Construction/FM Contractor, prior to terminating the Project Agreement and the Construction/FM Contract respectively). Advance notice of the identity of the proposed appointed representative must also be given to the Authority/Trust.
In addition, the lenders may procure the novation and transfer of Project Co’s rights and liabilities under the Project Agreement to a suitable substitute contractor. If this arrangement becomes effective, any subsisting termination notice or grounds of termination would have no further effect, and the lenders would provide funding to the substitute contractor under a new suite of finance documents.
Advance notice of the proposed substitute contractor must usually be given to the Authority/Trust for approval. Negotiations and political compromise are often at the heart of the novation process, and much would depend on the track record, technical expertise and financial resources of the proposed substitute contractor. It is of utmost importance to present a workable rectification plan in respect of any past breaches, and to instill confidence in the proposed substitute contractor.
These step-in and novation rights are designed to give the lenders a chance to prevent the wholesale collapse of the project. By appointing a suitable substitute contractor to operate the PFI/PF2 project, the lenders may be able to recover the loan from the revenue generated, and avoid incurring significant financial losses.
Restructuring options in the face of insolvency
The appropriate restructuring option depends on the provisions of the contractual documentation and the party becoming insolvent.
Insolvency of Construction/FM Contractor
The relevant Construction/FM Contract will most likely be terminated by Project Co upon insolvency. In this case:
- Project Co may procure a substitute Construction/FM Contractor. Depending on the status of the project, it may be difficult to source a suitable substitute contractor willing to take on the project without a substantial reallocation of the risks and liabilities
- the succession of contractors due to insolvency without a new procurement procedure is subject to regulation 72(1)(d) of the Public Contracts Regulations 2015—the substitute contractor must fulfil the criteria for qualitative selection initially established, and no substantial modifications should be made to the contract
- alternatively, Project Co may choose to directly engage the existing suppliers/sub-contractors by exercising its rights under any collateral warranties or direct agreements. In the absence of a new procurement procedure, regulation 72(1)(e) of the Public Contracts Regulations 2015 provides that modifications (if any) to the subcontracts must not be substantial. For further reading, see Practice Notes: Direct agreements in PFI/PF2 and Step-in rights in a collateral warranty, and Q&A: If a contractor is insolvent, can its sub-contractor claim outstanding payments directly from the employer?
- in the further alternative, the Authority/Trust may decide to take the relevant FM services in-house by voluntarily terminating the Project Agreement. It would be essential to consider the financial and resourcing implications before going down this route
Insolvency of Project Co
Upon Project Co insolvency, the Authority/Trust will most likely give notice to the lenders and, after the expiry of the ‘Required Period’, seek to terminate the Project Agreement. The Construction/FM Contractors may also seek to terminate the Construction/FM Contracts. In this scenario:
- during the ‘Required Period’, the lenders may exercise their step-in and novation rights under the funders direct agreements, and propose to transfer Project Co’s rights and liabilities under the Project Agreement to a suitable substitute contractor (with the Authority/Trust’s consent). This route allows the lenders to take control and recoup the loan from the revenue generated
- in the absence of any step-in/novation by the lenders, the Authority/Trust may procure a substitute Project Co without a new procurement procedure, subject to compliance with regulation 72(1)(d) of the Public Contracts Regulations 2015 as described above
- alternatively, the Authority/Trust may step in and directly engage the Construction/FM Contractors pursuant to any collateral warranties/direct agreements. In the absence of a new procurement procedure, regulation 72(1)(e) of the Public Contracts Regulations 2015 provides that modifications (if any) to the subcontracts must not be substantial
- if Project Co is a joint venture company, a simpler option may be to transfer the entire Project Agreement to the solvent partner within the joint venture. As the CJEU held in Case C-396/14 MT Højgaard A/S v Züblin A/S, a bidding consortium can be replaced by a solo entity after its partner’s insolvency, provided that the solo entity meets the initial qualifying criteria laid down by the contracting authority
- as far as FM services are concerned, the Authority/Trust may simply decide to take the services in-house after due consideration of the financial and resourcing implications, without any further outsourcing
Protective measures to counter insolvency risks
If there is a known risk of contractor insolvency:
- the Project Agreement usually confers a discretion on the Authority/Trust to require Project Co to appoint a replacement Construction or FM Contractor, and the Authority/Trust may wish to preemptively exercise this discretion to protect the viability of the project
- Project Co may also propose a replacement contractor on its own volition and seek the Authority/Trust’s consent, so as to ensure an orderly transfer of the works/services in advance of any insolvency
On the other hand, if there is a known risk of Project Co insolvency and any subsisting ‘Events of Default’:
- it would be prudent for the lenders to consider preemptively exercising the step-in and/or novation rights, and to do so in consultation with the Authority/Trust so as to appoint a substitute contractor. This can protect the continuous delivery of the project, with an orderly transfer of the rights and obligations under the project agreement
- further, the Lenders should promptly exercise their powers under the acceleration provisions of the Loan Agreement, and also take steps to enforce any security granted under the Security Agreements
If insolvency in a PFI/PF2 project appears imminent, and there are outstanding disputes between Project Co and the Construction/FM Contractors regarding performance failures, payment deductions, and compensation/relief events, the solvent party may consider protecting its position by referring a dispute to a contractual adjudication (which is commonly provided by PFI/PF2 contracts).
For instance, if there is an ongoing dispute with substantial sums of deductions and payments at stake, it is common for Project Co to resolve the differences swiftly through adjudication, in order to avoid making any overpayments which may well become irrecoverable from a Construction/FM Contractor at risk of insolvency.