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Focus: Infrastructure – May 2008

Updated commercial principles for Partnerships Victoria

In brief: In April 2008, the Victorian Government released the Updated Standard Commercial Principles as part of its Partnerships Victoria guidance material. Partner Emma Warren (view CV), Senior Associate Claire Scanlon and Articled Clerk John-Paul Santamaria look at what will change with the updated principles.

• Introduction
• Key changes
• Conclusion

Introduction

The Victorian Government released the Standard Commercial Principles as part of its Partnerships Victoria policy in June 2005. The Government has stated that the updated principles have been developed through a continual dialogue with government departments, agencies and the private sector. The general framework and assumptions underlying the updated principles remain the same and the Government has stressed that the updated principles are not a shift in Partnerships Victoria policy.

Key changes

Contract term (Section 3)

Previously, the principles stated that in no circumstances would the private party be subject to liquidated damages for late achievement of commercial acceptance. This was on the basis that, as late delivery resulted in a shortened contract term and accordingly, less service payments to the private party, the private party was sufficiently incentivised to achieve timely delivery.

The principles have now been amended so that the Government may levy liquidated damages in circumstances where its potential delay costs are greater than the aggregate service payments it is not required to pay due to the shortened operating term.

It remains to be seen whether the Government will make this determination as to its delay costs at the outset of a project and include the right to levy liquidated damages as an absolute right or whether the right will be an option exercisable only if delay costs reach a certain level.

Site conditions and due diligence (Section 4)

Generally the onus regarding site suitability rests with the private party. However, under the updated principles the risk of artefacts and latent geotechnical conditions at 'high risk sites' (previously referred to as brownfield sites) will be shared between the Government and the private party. Relief for latent geotechnical conditions will be limited to site areas that are either inaccessible during the tender period (preventing due diligence surveys from being carried out) or for which it is not reasonable or practicable to expect the private sector to carry out due diligence surveys.

The costs associated with artefacts and latent geotechnical conditions will be shared by reference to an agreed schedule of rates or a percentage split of the actual costs (for items not covered by the schedule of rates or where a schedule of rates is not used). The private party will be required to bid the schedule of rates to apply, which will cover variable costs such as labour, cranage and truck movements, and will therefore bear the risk of the actual costs being higher than the unit cost price included in its bid.

In order to incentivise the private party to manage the latent geotechnical condition efficiently, the entitlement to relief is subject to the private party providing prompt notification of its discovery of the condition and taking steps to mitigate the effects.

Under the new arrangements, the Government will usually appoint independent consultants to undertake due diligence investigations and prepare a site assessment report and the Government will endeavour to either novate or otherwise procure the benefit of the report in favour of the private party. However, the private party is required to expressly release the Government from any liability arising from the private party's receipt and future use of the report.

Consequences of a failure to achieve technical completion and commercial acceptance (Section 11.5.6)

The updated principles introduce a new 'event of default', which involves the application of a 'look forward' test in relation to completion. The event of default occurs (subject to a cure period) if an independent expert considers that there is no reasonable prospect that the private party will achieve 'technical completion' or 'commercial acceptance' by the date for technical completion or the date for commercial acceptance respectively.

The concept of a look forward test has become relatively common in recent deals and, in principle, should not concern the private party, provided that the reasonableness requirement is retained and the project agreement is clear as to the timing of the exercise of the right to conduct the look forward test.

Identified defects (Section 11.6)

The updated principles provide further guidance with regard to the rectification of minor defects in that minor defects that cannot be immediately rectified must be rectified within a reasonable time. A failure to perform rectification works in accordance with an agreed, project specific rectification plan will have financial consequences, for example reduced service payments until the defects are rectified.

Relief for construction delays (Section 12)

An important revision to the principles is that, subject to strict reporting obligations, time relief may be given if an event affects a critical activity on the critical path and directly causes a delay to achievement of completion of the facility. This change purports to give the private party access to any 'float' or contingency in the construction program. Previously relief was limited to circumstances where the final date of completion was affected by the delay.

The private party will now also be given relief for concurrent delays for an EOT event that is a compensation event, provided the compensation event has been caused by government.

A new compensation event has been introduced that covers delay in any works to be carried out by government where those works are required to allow for the relocation or decanting of equipment, staff or users of the facility (eg students or patients). This follows recent hospital PPP projects that have involved works being carried out by third party contractors, engaged by Government. While those works are performed outside the scope of the PPP project, the contractual arrangements between government and the private party need to recognise the potential impact that a delay in completion of those third party works may have on the ability of the private party to perform its obligations under the PPP contract.

Service requirements and specifications

Service failures/abatement and default (Section 14.3 and 14.5)

The updated principles clarify the specific categories of service failure as follows: 'availability failure', 'incident failure' and 'quality failure'. The distinction between an availability failure and an incident failure is that, for an availability failure to occur, one or more functional areas must be unavailable for use for its intended purpose, whereas for an incident failure, one or more functional areas is affected but is not rendered unavailable for use for its intended purpose. The example of an incident failure given is that a light bulb may have blown in an area but other lighting is available and therefore the area can continue to be used.

There are also some changes to the principles regarding concurrent service failures to take into account the new category of incident failure. For example, where two or more events occur which would deem an area unavailable, the level of abatement will be calculated by reference to the event with the highest failure event classification.

Utility services (Section 14.7)

Previously, the Government agreed to generally take the risk on the unit price of electricity. The updated principles have extended that principle to all utilities. With regard to volume risk, the Government will look to transfer the full volume risk for some or all utilities to the private party (particularly on projects where the private party takes demand risk (eg a toll road) or where the core service and therefore energy usage is reasonably predictable (eg schools)). Alternatively, the Government will look to share volume risk above a specific threshold, which will be an item to be bid by the private sector. There will also be no cap on the private party's exposure to volume risk, providing an incentive to the private party to design an energy efficient facility.

Government relief for private party failure to comply with service obligations (Section 14.8)

The Government has now moved to the position that, subject to limited exceptions, abatement of the service fee will be the sole remedy for which the private party is liable for a service failure. The specific exceptions are for claims for: third party injury or property damage, loss or damage to, or destruction of, the facility or site, costs incurred by the Government in rectifying a breach or default or in exercising its step-in rights and reasonably foreseeable economic loss suffered by government caused by the unlawful or negligent act or omission of the private party.

This acknowledgement will be welcomed by private sector project participants and financiers as providing certainty in terms of the private party's exposure for service failures.

Intervening events during the operational phase (Section 17)

Changes, similar to those referred to above in the paragraph relating to the construction phase, have been made to the definition of an 'intervening event' (being events which relieve the contractor from termination for failure to deliver the contracted services), the threshold requirements and the extent of relief and compensation to be granted for such events.

Interestingly, the principles provide that where the act or omission for which relief is given involves additional works to be undertaken by Government contractors, the relief may be made conditional on the private party entering into appropriate interface agreements with those Government contractors. The updated principles also make it clear that Government will not provide relief for events in relation to which the private party should have put in place appropriate contingency pans to mitigate the effects on its ability to perform its contractual obligations.

Change in control (Section 21)

The updated principles have expanded the application of the 'change in control' restrictions to material subcontractors of the private party.

A failure to obtain government consent for a change in control will, subject to some minor exceptions, give rise to the Government's right of immediate termination as a default termination event (where it relates to the private party) or a default subject to cure as an event of default (where it relates to key subcontractors or other relevant related bodies corporate). Where it is an event of default, the private party may be required to cure the event by replacing the third party.

However, the updated principles make it clear that it is only for projects where, for security or other public interest reasons or where the Government has placed particular importance on the identity, ability or financial strength of the initial key subcontractors in selecting the private party as the preferred bidder, that Government may require control over such subcontractors.

The principles have also been amended to provide the Government with an express right to withhold its consent to the proposed change in control if it is of the reasonable opinion that specified conditions apply. Previously the onus was on the Government not to withhold its consent. 

Modifications (Section 22)

The updated principles contain different mechanisms for government-initiated and private party initiated modifications.

The parties will be required to agree on the cost of preparing the proposal to implement the modification. If no agreement is reached, the Government may choose not to proceed with the modification, request a further quote from the private party or submit the matter to an independent expert. Additionally, during the bid phase, the private party will be required to bid fixed or maximum margins and other on-costs that the private party (or its subcontractors) may apply to the costs of certain modifications. The updated principles also confirm that the following activities will not be considered government-initiated modifications:

• during the operational phase, any minor works or any required refurbishment and maintenance works;
• the development and refinement of the design documentation in accordance with the project agreement;
• during the construction phase, minor design changes to the facility, works of a non-structural nature requested by Government that do not, in aggregate, increase the capital cost of the works or cause delay to the achievement of completion by the due date; or
• any other modifications required to ensure the facility is fit for its intended purpose.

Finally, the updated principles also create the possibility of a minor works regime. If implemented in a project, this regime will apply to works to be carried out (whether requested by the Government or the operator) during the operational phase, that fall under an agreed threshold and which are considered a routine element of administering the infrastructure. The works are deemed to be part of the services to be performed and the private party will not receive any additional margin or other costs for doing the works.

General change in law (Section 23)

There is no change to the principle that the risk of a general change in law is a shared risk. However, the updated principles provide that the Government will not give relief for cost increases in the provision of soft services arising from general changes in law. Those costs will be borne entirely by the private sector. The private party is protected against such cost increases through the combined effects of the procedures for review of soft services, market testing and indexation.

Force majeure (Section 24)

Under the updated principles, the private party's right to terminate as a result of extended force majeure (ie six to 12 months) has been clarified to be exercisable only after the expiry of the builder's advanced consequential loss insurance cover during the construction phase and where the private party is unable to recover under its business interruption insurance during the operation phase.

If the force majeure event is an event which is not required to be insured against under the contract and not ordinarily insured against by operators of similar facilities, then the relief payable is restricted to the lower of the actual senior debt commitments and the forecast senior debt commitments for the period of suspension.

Insurance (Section 26)

There have been a number of changes to the mechanism by which the Government will share some of the insurance cost increases. Instead of being reviewed retrospectively, the cost of insurances will be reviewed annually on a look forward basis to determine whether, and by how much, the actual cost of insurance for the following year varies from the projected costs.

Default (Section 27)

Several new events of default have been introduced, including (in addition to the 'look forward' completion test described above in paragraph 2.5):

• fraudulent or misleading and deceptive conduct by the private party in the performance of its obligations or otherwise in respect of the contract documents (which is broadly similar to a provision in the equivalent NSW guidelines);¹ and
• failure by the private party to cure an unauthorised change in control of a key material subcontractor by replacing the relevant subcontractor within a reasonable time.

An event that cannot be cured does not automatically give the Government a right to terminate but requires the private party to prepare a prevention plan to be considered by the Government. This is an important change, as it reduces the risk of certain events being a 'hair-trigger' to termination by effectively giving the private party an opportunity to overcome the event of default.

Termination payments (Section 29)

There have been a number of changes to the principles relating to termination payments.

Significantly, if there is a liquid market, the Government will now be entitled to sell the unexpired term of the project agreement and pay the proceeds of the sale to the private party. If the Government receives no compliant bids, the proceeds will be deemed to be zero. The liquid market test is whether there are a sufficient number of contractors in the prevailing market to ensure the price likely to be achieved is a reliable indicator of fair value. Government will not be entitled to re-tender the unexpired term of the project if the senior lenders have exercised their step-in rights and, having used reasonable endeavours to do so, have not procured the transfer of the private party's rights and obligations under the contract to a suitable substitute private party.

The updated principles provide further clarity in relation to the determination of the fair market value. The independent valuer must determine the net present value of the projected cash flows for the unexpired contract term calculated on a nominal, pre-tax basis and taking into account agreed rates of indexation and assuming:

• a reasonable time to achieve commercial acceptance;
• the subsisting grounds for termination have not arisen; and
• any breach of the contract arising before the appointment of the successful tenderer will not entitle the Government to terminate the contract.

Again, this is broadly similar to the determination of fair market value provisions in the NSW guidelines.² 

The updated principles also provide further guidance on the calculation of termination payments for bond financed deals. These can be summarised as follows:

• for voluntary termination, the calculation takes into account the lower of the net present value of the actual cash flows of outstanding bonds and the forecast future cash flows under the bonds forecast to be outstanding, having regard to the yield at which the bonds are priced on the market at the termination date;
• for a force majeure termination, government will only pay the par value of the bonds outstanding, less any deductions; and
• for a default termination, in determining the fair market value, the discount rate is calculated by reference to the real yield rate to maturity on a benchmark Commonwealth bond traded in the Australian markets with a comparable duration of outstanding senior debt.

Conclusion

In many cases, the changes to the principles reflect positions negotiated and agreed in recent PPP deals in Victoria. As a result, private sector parties that participate actively in the Victorian PPP market will not see a marked difference in the approach taken on current and forthcoming PPP projects.

Given the current unease in the infrastructure market because of the global liquidity crisis, the Government's decision to provide greater certainty on its approach to risk allocation between the Government and private sector in a number of key areas and, in doing so, to follow best practice in the market, will be welcomed by project sponsors, subcontractors and financiers.

While the Government has not yet produced draft standard contractual clauses reflecting the Standard Commercial Principles, a move that would be welcomed by many, the updated principles reflect the Government's continued efforts to maintain open dialogue with industry participants and other governments and to seek to apply the lessons learnt through further review and refinement of the principles.

Footnotes

1. NSW guidelines – section 27.CA 9.
2. NSW guidelines – section 29.1.1.SC 306.

For further information, please contact:

• Emma WarrenPartner, Melbourne
  Ph: +61 3 9613 8856
  Emma.Warren@aar.com.au
• Leighton O'BrienPartner, Sydney
  Ph: +61 2 9230 4205
  Leighton.Obrien@aar.com.au
• Alan MillhousePartner, Brisbane
  Ph: +61 7 3334 3149
  Alan.Millhouse@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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