2.22 Current guidance recommends that any PFI contract should specify precisely what compensation is payable if the contract is terminated early. The guidance supports the payment of compensation to the private sector party where he is unable to perform his obligations, and the contract is terminated. It argues that this is justified where particular assets are developed to deliver particular services and the public sector is entitled to have the assets transferred to it on the contract's termination, since the transfer of these assets without the payment of compensation would unfairly benefit the public sector body. Such termination payments are also desirable as they give the banks assurance that they may receive back at least some of their lending on a failed PFI project. Without such an assurance the banks would charge higher interest rates for the financing that they provide.
2.23 The above provisions differ from Treasury's approach at the time of the deal. The Treasury had agreed in July 1992 to the contribution by the Department of £20 million to the costs of constructing the new museum on the basis that, should the private sector party default, ownership of the museum should pass to the public sector at no cost. The agreement for the new museum therefore made no provision for the payment of any compensation in the event of voluntary termination or default by the private sector partner. Given the uncertainty surrounding the ownership of the new museum in the event of the contract's early termination for RAI's receivership (paragraphs 1.67 to 1.69), the Armouries and the Department considered that, although not required by the contract, in practice there would have to be a payment to the Receiver or RAI's lenders in order to get ownership relatively quickly if RAI did go into receivership.
2.24 PFI contracts have contained a wide range of provisions for paying compensation to a private sector party when he defaults. Arrangements have varied from no compensation to full payout of senior debt. Current guidance recommends that the amount of compensation payable when the private sector party defaults should protect the public sector body's interests while not unreasonably penalising the private sector party for default. It should also encourage the senior lender to step in and rescue the project instead of relying on termination payments to pay the outstanding debt.
2.25 The guidance therefore recommends the payment of compensation based on the market value of the unexpired period of the contract.14 Market value is established either by retendering for the remaining period of the contract, or, if there is no market for the contract, the public sector body pays an assessed value of the amount it would have received from a retender in compensation. The guidance states that, if the assessed value of the contract is negative, then the public sector body has a right to an equivalent amount of compensation from the private sector party, although the guidance states that the public sector body is unlikely to obtain any significant recovery.
2.26 In the case of the Armouries project, it is very unlikely that there would have been bidders for the unexpired period of the agreement, given the expected level of losses if the joint venture had continued in its current form, the lack of total control over income generation activities and the delays to the Clarence Dock redevelopment. This suggests that the contract would have had a low, or even negative, market value and so a low level of compensation would have been payable to RAI or its lenders if the contract had been terminated for RAI's insolvency. Therefore, under current guidance, it is likely that any compensation payable to the Bank if RAI had gone into receivership would have been insufficient to pay off all the debt that RAI owed it. This mirrors the effective consequences of the actual contractual provisions and the restrictive covenants contained in the contractual documentation on this deal (paragraphs 1.67 to 1.71).
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14 Standardisation of PFI Contracts paragraphs 20.2.5.1 and 30.3.8