Focus: Infrastructure – April 2008
Infrastructure projects in troubled economic times
In brief:
Australia's vibrant economic conditions in recent years has led to a thriving
appetite for infrastructure assets. However, the recent turmoil in global equity
and financial markets has coincided with a severe tightening of credit
generally. This change in economic circumstances will impact on the financing
and delivery of new projects and the refinancing of existing projects. Partner
Alan Millhouse
How does it affect you?
- With the economy showing signs of stress, it is crucial that all parties to infrastructure projects carefully consider all aspects of their project contracts to make sure the project has the best chance of success.
- If things go wrong on a project, the project company's directors will need to bear in mind their likely obligations.
Successful infrastructure projects: issues to tackle
Power of the government parties to contract
As the number of infrastructure projects (including public private partnerships (PPPs)) continues to grow, project participants and their financiers will need to investigate and be satisfied that the relevant government party has the power to contract in the manner contemplated by the project in question.
This is a particular issue for local governments, whose statutory powers are often more constrained and legislative enlargement of their powers may be required.
Government guarantees or other support
With most PPP projects, a lengthy concession term or service contract period will be the norm to financially underpin the level of private sector investment that is likely to be necessary. A prolonged concession or service provision period will be of no concern where the public sector counterparty is either the government or another entity representing the Crown (so that, in effect, the obligations are government obligations). However, if the public sector entity does not represent the Crown, prospective project participants and their financiers may consider obtaining a government guarantee.
Project participants and their financiers will often be unwilling to assume the credit risk of a public sector authority in such circumstances, especially if there is any realistic likelihood that:
- the public sector entity might be privatised during the life of the project; or
- the industry in which the project company operates is likely to be restructured in a way that may impact adversely on the project company's projected revenue streams.
Government security – ranking and priority
In many PPP projects, the project structure is typically an incorporated joint venture. The government will often be contracting with a party that is a lowly capitalised special purpose company with no track record of service delivery and whose main asset will be its interest under the project documents.
Governments may therefore require that the project company provide additional security, such as a fixed and floating charge over its assets, to secure its various obligations to the government. This will typically occur where, for example, the project is structured on a BOOT basis, to ensure that the project company's obligation to transfer unencumbered title to the project assets to the government at the expiration or earlier termination of the concession term is appropriately secured.
The project company's financiers will wish to ensure that any government security will rank behind their first ranking security.
Step-in and cure rights
In a PPP context, the manner in which step-in rights, which are rights given to the government and the financiers to take over some or all of the project company's obligations for a certain period and in certain circumstances, are addressed in the project documentation will be of critical interest to the government, project financiers and the other project participants.
Financiers will invariably wish to negotiate an acceptable direct agreement with the government (often called a tripartite or consent deed) to regulate, among other things, the financiers' step in rights and priority issues.
Quite properly, such agreements are increasingly being seen as advantageous to the public sector, as they provide financiers with an opportunity to revive the project and, consequently, to avoid the disruption that inevitably follows termination. If the project can be restored with minimal disruption to the contracted services and there is no need for the government to become involved to procure that outcome, both the government and the financiers benefit.
Damage and reinstatement
In traditional projects, if a project is damaged, the project participants and their financiers will determine the commercial viability of reinstating the project. There is usually no compulsion for them to reinstate if they elect not to do so.
However, in the case of PPP projects, the position will generally be different and, if an insured event occurs and certain project assets require replacement or reinstatement, the potentially competing interests of the government (which will be anxious to ensure a continuation of services), the project company and its financiers need to be carefully considered and resolved.
Insurance and termination
Insurance coverage for both the works comprising the infrastructure project and, post-completion, for the operational stage are a critical requirement from the perspective of the government, project participants and their financiers. In the event of a major or total loss, the project insurances will often be the only viable means of repaying the financiers.
Termination of government concessions has been an area of critical, and often controversial, interest for project sponsors and their financiers.
The government, project joint venturers and their financiers will be anxious to ensure that the project contract deals comprehensively with the events leading to, and consequences of, all types of termination and, in particular, the important issues of what happens to the project assets and what quantum of compensation (if any) is payable by the government in the event of termination, particularly where termination is due to the project company's default.
This issue presents a significant negotiating challenge, as the project contract must achieve a fair and bankable balance between:
- the government's desire to be able to terminate for inadequate service provision, even if caused by relatively minor, but persistent, defaults (a right that government parties are used to having in conventional service contracts); and
- the project company's and its financiers' interest in restricting termination to the severest of defaults, when all other reasonable options have been exhausted (including reasonable rectification or cure periods in favour of the project company under the project contract and in favour of the financiers under a direct/tripartite agreement between the financiers and the government).
Many concession agreements (especially in the road and rail sectors, where the prospect of default following construction is more remote) have stipulated that no compensation is payable in the event of termination because of default of the concession holder.
Financiers' acceptance of such an arrangement will usually require a strongly protective direct/tripartite agreement between the financiers and the government (incorporating a generous cure regime) and a high degree of confidence on their part as to the ability of the project company to complete the project and perform its service obligations.
The need for direct/tripartite agreements with key parties
Direct or tripartite agreements are agreements entered into between the project company, its financiers and the other parties to the projects' key underlying commercial contracts.
Such tripartite agreements, which are invariably sought in traditional project financings, will assume the same critical security relevance for infrastructure projects generally, especially if no compensation is payable on a termination because of the project company's default. Their principal objective is essentially to enable the financiers to step into the shoes of the project company, if it defaults in its financing obligations, to facilitate enforcement and sale.
Procurement of services – the critical concepts of availability and performance
The essential ingredient of most PPP infrastructure transactions is the procurement of a service. It follows, therefore, that unavailability of the service should result in a reduced payment by the public sector counterparty or, in certain circumstances, no payment at all.
In order to raise project finance, the amounts payable under the PPP project documentation must be predictable. A key issue in most PPP projects will therefore be what constitutes availability.
Projects that are predicated upon availability-based payments must therefore incorporate in the project documentation what is meant by availability.
The definition of availability will be more straightforward in some sectors than in others.
Change in services
Given the duration of most PPP projects, it can be anticipated that the nature of the contracted services will need to be varied during the life of the contract.
Any proposed change in services may involve construction and/or operational changes. Depending upon their nature, costs may be incurred in implementing changes that were not originally anticipated.
From the project participants' and financiers' perspectives, the critical issues regarding changes in services proposed by either the government or the project company are:
- whether the changes are mandatory; and
- how the cost of implementing such changes is to be allocated.
Service charge variations
The project contract will usually set out the service charge for the entire contract term. However, because of the uncertainties of inflation rates and the quantum of operating costs over a long-term contract, the project sponsors and financiers will be concerned to ensure that the contract provides for a variation in the service charges in certain specified circumstances.
The project company will also need to insulate itself against inflation rates increasing over the course of the contract and rendering the initial prices insufficient to meet its operating costs and financing obligations. It would be highly unusual for prices to be fixed for periods for which PPP projects are typically let. Governments should therefore accept that appropriate indexation mechanisms may be incorporated. Great care is needed in selecting and drafting those indexation provisions.
Taxation issues
Project joint venturers and their financiers will, of course, need to seek specialist tax advice for all infrastructure projects to ensure that base case financial models and after-tax cash-flows are predicted accurately. Principal issues in relation to income tax in this context will include:
- Division 250 of the Income Tax Assessment Act 1997 (Cth);
- the depreciation and capital allowance provisions;
- the thin capitalisation rules; and
- the tax consolidation regime.
What if things go wrong?
The collapse of a project company is usually preceded by early warning signals, such as requests to waive or relax borrowing covenants. The project company's directors will usually know that the company is in financial difficulties in advance of its financiers and that knowledge attaches legal responsibilities to the directors, which will influence the actions they take until the company either descends into some form of insolvency or is successfully restructured.
The project company's directors will owe duties to its creditors to prevent insolvent trading. If encountering financial difficulty, the project company's directors will need to bear in mind their following likely obligations:
- the directors must deal with the company's creditors honestly and openly;
- they should formulate accurate forecasts of the company's likely financial position in the short to medium term and whether there is any reasonable prospect of the company surviving its current financial difficulties;
- if directors conclude there is no reasonable prospect of avoiding insolvency, they must promptly explore the possibility of an injection of further equity from the company's shareholders;
- if an equity injection is not forthcoming, directors must then consider whether insolvency can be avoided with the company's creditors and financiers. There are a range of formal procedures in Australia if a project company is in financial difficulty, namely receivership (usually only if security has been granted to lenders), administration, provisional liquidation, liquidation, or scheme of arrangement;
- after disclosing the company's predicament to its creditors, the directors should then consider whether a contractual workout is to be preferred to more formal insolvency proceedings. A 'stand-still agreement' may be possible with financiers and creditors under which the financiers and creditors will commit not to institute insolvency proceedings until all interested parties can ascertain if a workable solution to the company's financial difficulties can be found;
- sensible and effective cost-saving measures must be explored;
- frequent board meetings will be critical. The company's financial records and budgets must be continually reviewed and kept up to date; and
- if directors conclude at any time that there is no prospect of the company trading out of its financial difficulties, some form of formal insolvency proceeding must inevitably follow.
Given that the project company's financiers are likely to be not only the project company's most significant creditors but also an obvious participant in any refinancing or restructure, it is critical to keep those financiers fully informed. If, as will usually be the case, those financiers hold security over the company's assets and the directors conclude that there is no longer any reasonable prospect of avoiding insolvency, the directors should consider inviting the financiers to exercise their default powers (usually by the appointment of receivers) rather than pre-empting them by themselves seeking to appoint administrators or liquidators to the company.
From the financiers' perspective, it is important to note that an administrator is entitled to be indemnified out of the borrower company's assets for debts and liabilities he or she has incurred as administrator, as well as his or her own remuneration. This right of indemnity is secured by a lien over the borrower company's assets, which will enjoy priority over all debts secured by a floating charge (but not a fixed charge), until the administrator receives written notice of the appointment of a receiver under the charge.
A financier with a charge over the whole, or substantially the whole, of the borrower company's assets may enforce it (during the first 13 business days following notice of the administrator's appointment) and appoint its own receiver. While a receiver will also insist on a right of indemnity, the receiver's role will be much more limited, as the receiver's primary duty will be to realise the secured assets for the benefit of the financiers. However, an administrator owes a broader duty to the unsecured creditors, which means an administration is often likely to be a more costly procedure than a receivership and potentially less aligned with the secured financiers' interests.
If the project company is unable or unwilling to provide an 'all assets' charge, a convenient method of addressing and mitigating these administration risks is for the project company to grant a regular charge or mortgage over specific assets securing the relevant debt, together with a 'featherweight' floating charge over its remaining assets (which is typically drafted only to crystallise and become enforceable if an administrator is appointed). The secured financiers will then have security over the whole of the project company's assets and can proceed to appoint a receiver if the project company were to descend into administration.
For further information, please contact:
- Alan MillhousePartner,
Brisbane
Ph: +61 7 3334 3149
Alan.Millhouse@aar.com.au - Leighton O'BrienPartner,
Sydney
Ph: +61 2 9230 4205
Leighton.Obrien@aar.com.au - Emma WarrenPartner,
Melbourne
Ph: +61 3 9613 8856
Emma.Warren@aar.com.au - Michael HollingdalePartner,
Perth
Ph: +61 8 9488 3708
Michael.Hollingdale@aar.com.au - Matthew BarnardInternational Partner,
Hong Kong
Ph: +852 2903 6212
Matthew.Barnard@aar.com.au
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