31.7.1 A number of projects have been closing in the PFI market where Senior Lenders have sought to add blanket subordination provisions to the form of the Direct Agreement which, in extreme cases, might act to negate the benefit of the Authority's own direct agreements with key Sub-Contractors and consultants.
31.7.2 An Authority should have no wish to upset the normal arrangements which Senior Lenders enter into or to upset the Senior Lenders' incentives to take responsibility for monitoring the Contractor (and where necessary to take control of its affairs and sub-contracts); equally however it will wish to be able to preserve continuity of services and build, and will not want the benefit of its own step-in arrangements negated. There should ordinarily be no conflict between the interests of the Senior Lenders and of the Authority - both of whom will want to ensure continued Service provision.
31.7.3 If, however, for some reason Senior Lenders do not choose to exercise their rights under their direct agreements with key Sub-Contractors and consultants, or having exercised such rights have stepped out, the Authority may wish to exercise its own rights under its own direct agreements to preserve continuity of Service, for instance, with a valued non-defaulting Sub-Contractor. Blanket subordination provisions, preventing the Authority from exercising its rights until the Senior Debt is fully paid out, might preclude this.
31.7.4 Set out below is some suitable drafting which Authorities may find helpful. For periods after Project termination, where notice periods allowing Senior Lenders to step in have elapsed and they have chosen not to step in to Sub-Contracts, the Authority may step-in (though the Senior Lenders' own claims against sub-contractors may be preserved). In the period prior to project termination before the notice period to Senior Lenders may have elapsed, the Authority may agree not to step in to subcontracts but may still wish to be able to fund them to prevent their termination. This is likely to be a remote and short term contingency prior to Project termination.
31.7.5 An Authority will also wish to ensure that the operational assets which the Authority needs to complete or operate the Project pass across from the Contractor to the Authority on a termination - so as to ensure continuity of service. These principles are set out in Section 31.3.8 and Section 21 (Early Termination) and the Senior Lenders' security arrangements should not overturn them. This should not be a concern for the Senior Lenders (whose main interest should be the Termination Sum or the cash sum paid in the market for the Project on a default). It is in the interests of the Senior Lenders that the Project remains operational and can be sold in the market for its maximum value. Their real security is in the cash flow (or termination sum) rather than in assets. The operational assets involved are not likely to be major items in most Projects.
Suitable drafting is as follows:
31.7 Authority rights under Direct Agreements [and Appointments]
31.7.1 Notwithstanding any provision in the Authority Direct Agreements [and/or the Appointments] to the contrary, the Authority agrees that, subject to Clauses 31.7.2 and 31.7.3, it will not, in respect of any particular Authority Direct Agreement [or Appointment], exercise or seek to exercise any of its step-in rights or other rights under such agreement or until the earlier of:
(a) the Senior Debt Discharge Date; or
(b) the date on which the Agent has given its written consent to such exercise; or
(c) the time when in respect of any such Authority Direct Agreement [or Appointment] either:
(i) the Senior Lenders have failed to exercise any corresponding right to such Authority Direct Agreement [or Appointment] under their own Security Documents and the time for exercising such right has ended in accordance with the terms thereof; or
(ii) the Agent has confirmed in writing to the Authority (following any request from the Authority for such confirmation, to which the Agent shall be obliged to respond promptly) that it does not intend to exercise any of its rights under the relevant Security Document or that it has no further claim thereunder; or
(iii) the Senior Lenders have stepped in to, or otherwise, directly or indirectly, taken control over the rights of the Contractor under, such agreement (in accordance with their rights under their Security Documents) and then stepped out from, or otherwise relinquished control of such rights under or in connection with such agreement.
31.7.2 In addition to its rights under Clause 31.7.1, where the Contract has not been terminated but a counterparty has a right to terminate its sub-contract [or Appointment] for breach by the Contractor of the terms of such sub-contract [or Appointment], the Authority may pay directly, or undertake to make a payment directly to the counterparty concerned, amounts due pursuant to the sub-contract [or Appointment] and may set off any such sums against any payments payable by the Authority to the Contractor under the Contract, so as to satisfy them pro tanto, provided always that the Authority shall not exercise its rights under this clause 2.2 in respect of any particular such sub-contract [or Appointment] in circumstances where the Senior Lenders have stepped in to, or otherwise, directly or indirectly, taken control over, the relevant sub-contract [or Appointment] and not stepped out of it or otherwise relinquished such control.582
31.7.3 In addition to its rights under Clause 31.7.1, where the Contract has been terminated, the Authority shall from the Termination Date be able to exercise any of its step-in rights or other rights under or in respect of any of the Authority Direct Agreements [or the Appointments]; however, notwithstanding the terms of the Authority Direct Agreements [or Appointments] or any other provisions of this Clause 31.7.3, each of the relevant sub-contractors [or the counterparties to the relevant Appointment] (and any guarantors thereof as relevant) shall remain responsible, and be liable, to the Contractor in respect of all costs, claims, damages, losses and liabilities which shall have arisen out of or in connection with the relevant sub-contracts [or Appointments] in respect of the period prior to the Termination Date in relation to which the Agent acting on behalf of the Contractor or the Senior Lenders shall retain the benefit of all and any rights to all such costs, claims, damage, losses and liabilities.
31.7.4 Except in accordance with the provisions of Clauses 31.7.1 to 31.7.3 (inclusive) and 31.6 the Authority shall not, prior to the Senior Debt Discharge Date:
(a) claim, recover, retain or receive (or seek to claim, recover, retain or receive) any amount under the Authority Direct Agreements [or the Appointments] in respect of a loss for which a sub-contractor or relevant counterparty is also liable to the Senior Lenders;
(b) take any action to wind-up, appoint an administrator, seek an interim order appointee (under paragraph 3(b) Schedule B1 of the Insolvency Act 1986 (as amended)), or sanction a voluntary arrangement (or similar) in relation to the Contractor; or 583
(c) save with the prior written consent of the Agent, compete on grounds (whether in whole or in part) relating to the Project (by virtue of a claim under any of the Authority Direct Agreements, [the Appointments], the Contract or any other Project Document or otherwise) with the rights of the Senior Lenders on any formal insolvency of any sub-contractor, [any counterparty to any Appointment] or the Contractor, nor claim to be subrogated to any rights of any Senior Lenders.
31.7.5 The Authority agrees and undertakes that if it receives any amount in contravention of the provisions of Clause 31.7 above, it will promptly turn the same over to the Agent and pending such payment, hold the same on trust for the Agent and the Senior Lenders.
31.7.6 Notwithstanding the terms of the Contract and Security Documents, the Agent agrees that the Authority may exercise its rights to have transferred to it or its nominee any Unrestricted Assets following the Termination Date and the Agent will not exercise or seek to exercise any enforcement rights, and shall, on or before the date any Unrestricted Assets are transferred to the Authority or its nominee, as the case may be, release its security over them.
31.7.7 Notwithstanding any terms of the Financing Agreements, the parties agree and shall, to the extent it is within their power, direct that all insurance proceeds receivable or received by the Contractor under the insurances referred to in Clause [ ] of the Contract (Insurance) shall be paid directly into the Insurance Proceeds Account and applied in accordance with the Contract. 584
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582 This provision deals with the period prior to any project termination, and may include, for instance, a period when the Authority wishes to terminate and has given the required period of notice to Senior Lenders (e.g. 90 or 120 days) under Clause 3. It will be for Authorities to determine on a Project or sector basis the provisions of this Clause 31.7.2 and of the Direct Agreement whether or not they think it appropriate to further qualify or limit their ability to set off such payments. Clearly the preferred position for the public sector will be to retain the ability to "set off" any such payment to subcontractors so as to reduce the unitary charge, (and avoid "double payment") and Authorities will want to achieve this. Senior Lenders, may however argue that set off should be limited or qualified, for example, by reference to a period, or made dependent on the Senior Lenders' own attempts to preserve continuity of Service (see below).
"[or unless the Authority reasonably believes that the Senior Lenders are not seeking to preserve continuity of service or build obligation (as relevant) under the relevant Sub-Contract [or continuity of [ ] under the Appointment] with reasonable diligence (or under any equivalent service or build obligation under the Contract)]"
Any further subordination protection in any event should never extend beyond senior debt service (so as to benefit junior lenders or equity) or to impinge on the Authority's rights to step into the Project Agreement under Section 29 (Authority Step-in).
For periods after project termination Authorities will have the benefit of the standard netting and rectification cost provisions (See Section 12 (Set-off)).
583 Note: this would be instead of Clause 11(b) of the Direct Agreement - See Section 31.6 (Direct Agreement )
584 If preferred, this could be inserted in paragraph 9 of the Direct Agreement.