5.1.6 When the contract ends
A PPP contract should include detailed provisions dealing with the termination of the contract. The main issues to be addressed are:
□ the circumstances in which the contract may be terminated by a party;
□ the payment (if any) that must be made by the public authority to the PPP company upon termination (depending on the circumstances); and
□ the condition of the assets when they are handed over to the public authority following a termination.
As a general remark, it should be stressed that the early termination should not alter the initial balance of the contract, as this might be considered an unlawful modification.
This sub-section will focus on the second point above but will also briefly discuss the other two topics.
a) Grounds for termination
The typical grounds for termination are:
□ Expiry at the end of the contract term
□ Default by the PPP company
□ Default by the public authority
□ Voluntary decision by the public authority ("convenience termination")
□ Termination in the case of prolonged force majeure
The contract should describe in detail the circumstances that will allow a party to terminate the contract because the other party has defaulted on its obligations. The contractual breach has to be fundamental in nature. For example, the public authority would normally be entitled to terminate the contract in the case of the insolvency or bankruptcy of the PPP company or an egregious deficiency in service standards (e.g. where health or safety is threatened) that is not promptly remedied. A detailed list should be included of all the breaches that entitle termination.
Especially difficult can be how to handle the common problem of "persistent breach" - the accumulation of many breaches, each of which would not be enough to trigger termination but all of which together constitute fundamental non-performance. It is good practice to try to make the criterion to assess the existence of persistent breach as objective as possible - e.g. by specifying a value of accumulated penalties, deductions or performance points (over a specified period of time) that will be used as the trigger.
The typical example of default by the public authority is non-payment of the service fee (or other payment due to the PPP company), including cases in which the public authority has not adequately adjusted the company's remuneration in accordance with the terms of the contract, in response to various contingencies that have arisen. Another (broad) example is serious interference with ability of the PPP company to perform.
b) Termination payments
The public authority may be required under the contract to make payments to the PPP company if the contract is terminated. These provisions are generally complex and need to be carefully drafted with the assistance of specialised advisors. They require the balancing of a number of considerations, especially:
□ fairness;
□ incentives; and
□ an appropriate trade-off between conceptual correctness and certainty (this will be illustrated below).
The specification of termination payments can be important even if the contract is never terminated. For example, if the public authority is renegotiating the contract with the PPP company, it should not accept an outcome that would be less favourable to it than simply terminating and making the requisite payment. So the termination payment becomes the "reservation price" in the renegotiations.
The following sets out in a simplified way the approaches for calculating the termination payment for different kinds of termination. 
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Expiry of contract
PPPs are usually structured so that the public authority makes no payment to the PPP company when the PPP expires at the end of its normal term. But under certain circumstances, payments will be provided for. For example, if new assets have been constructed in connection with an extraordinary event, the terms of compensation may include a lump-sum termination payment to be made by the public authority, as well as an increase in the periodic service fee during the remaining term of the PPP.
Termination for default by the PPP company
Termination for contractor default is the final stage of a process which commences when a project is failing to perform to expectation. The PPP contract would be expected to set out the various circumstances which could trigger termination. These will include failure to complete construction, persistent failure to meet performance standards and the insolvency of the private sector partner. The contract will also set out the circumstances in which failure to perform can not be used to trigger termination (sometimes known as "relief events").
In the first instance of serious failure on the part of a contractor (e.g. insolvency, poor performance, corruption etc.), the PPP company would be expected to replace non-performing sub-contractors and seek termination damages from the replaced contractor. These should be set at a level which would allow the project company to meet any additional costs associated with the replacement contractor.
In the case of default by the PPP company, lenders would expect to be allowed to step-in to save the PPP project and the public sector would be expected to permit, and rely on, lenders to control the PPP project. The right of step-in is typically foreseen in a direct agreement entered into between the project company, the lenders and the parties to the project's key underlying commercial contracts.
The PPP contract will be terminated only if lenders choose not to step-in, or choose to step out of a non-performing project. It would be normal that in these cases equity would be entirely lost and no compensation would be payable to shareholders. Compensation for transfer of the PPP project assets may be payable to senior lenders. This will be determined either through the provisions of the PPP contract, the applicable legal code, or where the public sector has agreed to guarantee part of the project's senior debt.
As a general principle, the public sector should not be incentivised to seek early termination, but equally lenders should not expect to avoid loss where the public sector is incurring additional costs. In practice, a number of mechanisms can be employed to achieve a balanced result:
□ For example, in a typical PFI arrangement in the UK, where there is a liquid market in similar projects and the early termination is due to default by the project company, the procuring authority can choose to "sell" the unexpired period of the project contract and the best bid capital sum obtained as a result of such "sale" will be used to pay compensation to the lenders (so-called "market value based compensation on termination").
□ Where there is no liquid market in similar projects the amount of the lenders' compensation will typically be determined by the present value of future cash flow under the project minus present value of future costs minus rectification costs (so-called "fair value based compensation on termination").
The insolvency of the PPP company is an important cause of contractor default. In traffic risk projects, this could occur when the failure of traffic volumes to grow sufficiently in the early post construction years means that the PPP company can no longer service its debt in line with the agreed schedule. In this case, lenders could choose to 'accelerate' their debt (i.e. make the entire debt due and payable) - this would force the PPP company into insolvency. In this scenario, the incorporation of the LGTT in the financing structure could significantly reduce the risk of default. It would, therefore, also reduce the potential call on any guarantees offered to senior lenders by the public authority.
It is generally accepted nowadays in PPPs that, if the assets financed under the project remain with the public, the public authority should often make a termination payment to the PPP company even if the contract has been terminated for default by the PPP company. Otherwise, the public will have received an unjustified windfall. Given that most or all of this payment will go to lenders, the shareholders of the PPP company will emerge as losers in this kind of termination - which is as it should be since the PPP company was at fault.
This is a key issue in the PPP contract, and of considerable importance to the bankability of the deal. There are different methods used to calculate the payment that the public authority must make to the PPP company (which must be used as first priority to pay lenders), including:
□ repayment of outstanding debt (to the extent it has been properly used for project assets) or a pre-specified percentage of outstanding debt;
□ depreciated value of assets financed by debt (there are several variants of this general approach);
□ present value of expected future net cash outflow to be avoided by the public authority by terminating the contract (i.e. the service fee less all costs that the public authority will have to incur); and
□ open-market sale (the public authority rebids the PPP contract, selects a new company that will continue with the contract and then pays to the original PPP company the proceeds it receives from the sale).
Methods actually used can combine the different approaches in various ways. Each of these methods has pros and cons. For example, it is argued that lenders should not be assured of 100% recovery because that would remove their incentives to conduct thorough due diligence and careful project monitoring. Another example: the open-market-sale method will not work well if there is no liquid market for PPP contracts. Finally, the method involving a net present value calculation may be conceptually appealing, but making forecasts of future costs and revenues can be highly speculative and lead to disputes. Parties therefore often prefer solutions involving the certainty of easily determined values and clear calculations.
Termination for default by the public authority; or voluntary termination
A long tradition in contract law, supported by considerations of fairness and correct incentives, argues in this case for putting the PPP company in the financial position it would have been in if the contract had not been terminated but had run its course ("expectation damages"). Lenders should therefore be fully compensated. The problems arise with how to calculate the payment due to the equity holders. Generally, some form of discounted cash flow measure is used. Variants include the following, each having pros and cons:
□ Net present value of what the future cash flows to equity holders would most likely have been, from the termination date up to the normal end of the PPP contract. This is the most conceptually correct method, but it suffers from the uncertainty of the forecasts that would need to be made.
□ Same as above, but based on the pro forma cash flows in base case financial model. This has greater certainty but might suffer from problems relating to fairness and incentives (e.g. if the project is doing much better than expected in the base case, it might give the public authority an incentive to terminate the contract).
□ A payment that will give the equity holders the IRR they expected, based on all cash flows from the beginning of the contract up to (and including) termination. This can have the advantages of more certainty in the early years of the PPP contract - e.g. before the operating phase has begun.
Termination for prolonged force majeure
The basic principle in this case is that since neither party is at fault, the burden should be shared in some way. Therefore, the required payment will often be somewhere between those required in the cases of PPP company default and public authority default. It may be, for example, that outstanding debt is paid and sometimes also the value of the equity injected into the project (but not a return on that equity).
Other details
The description above gives just the rudiments. The PPP contract will have to include other components and give greater precision about many of the elements of the calculations, for example:
□ how sub-contractors' costs related to termination should be dealt with;
□ how to categorize for these purposes mezzanine and other subordinated debt (i.e. which types are to be treated like senior debt and which types like equity?);
□ how to deal with reserves, insurance proceeds, etc.; and
□ the precise specification of the discount rate to be used for each type of present value calculation (nominal or real? pre-tax or post-tax? based on the base case financial model or on current market values, or on both?).
c) Condition of assets at expiry of the PPP contract
The PPP contract should contain provisions to ensure that the assets are handed back to the public authority in good condition. For example, the contract could include provisions such as the following: <2>,<4>
□ Clear principles describing the condition the assets must be in at contract expiry (e.g. expected useful life to be remaining for each type of asset, or ability to meet certain performance tests)
□ Assessment of asset condition and description of works to be completed, made by an independent expert sufficiently in advance of the expiry date
□ Possibly, deductions to be made from the service fee during this final period, the proceeds of which to be held in an escrow account
□ Verification by an independent expert that the needed works have been completed adequately, and subsequent release of retention money to the PPP company