27.2.1 The Authority should require copies of financing documents from the winning bidder in advance of Financial Close, to allow it sufficient time to conduct its due diligence over the documents. The Authority's advisers should understand the areas to be focussed on in the due diligence process, which will include (amongst others) the following:
• Interest rate ratchets - it is common for the interest rate margin to reduce after the Service Commencement Date. The Authority should ensure that any change in margin reflects that set out in the financial model.
• Maintenance and other reserving mechanisms - the Authority should review the Senior Lenders' requirements in respect of the funding of the maintenance and other reserve accounts and be comfortable with the levels required. Moreover, the Authority should confirm that upon early release of reserving requirements, such release would be caught by the refinancing sharing mechanim3
• Letters of Credit - financing documents frequently allow the Contractor to withdraw the proceeds of reserve accounts and replace them with letters of credit (in a form agreed at financial close). Whilst the Authority should not object to such mechanisms in principle, it is important to ensure that the benefit of any such letters of credit are taken into account in the calculation of compensation on termination and that:
(a) the amount capable of being claimed under the relevant letter of credit is set-off from the amount paid by the Authority to the Contractor. Without such protection, the Contractor will effectively be paid twice; and
(b) the letter of credit does not automatically terminate on termination of the Contract. The effect of automatic termination of the letter of credit will be that the Authority pays a higher compensation amount.
Accordingly, the Authority should require a pre-agreed form of letter of credit to be included in the financing documents if the Senior Financing Agreements contain a mechanism for replacing reserve accounts with letters of credit. Releases of letters of credit should be treated in the same way as releases of funds from reserve accounts under the Refinancing provisions.
• Breakage Costs - the Authority must understand how any breakage costs are calculated under the financing documents. Breakage costs under interest rate hedging agreements (typically documented under the ISDA standard form agreement) should be calculated using the "Second Method and Market Quotation" formula which ensures that the breakage cost payable by the Authority is the "net" amount payable by the Contractor to the bank(s) after taking into account amounts owed by the bank(s) to the Contractor ("Second Method") and competitive ("Market Quotation"). Excessive break costs on termination of hedging arrangements should be avoided (see Schedule 1 footnote to the definition of Base Senior Debt Termination Amount.4 In addition, Authorities should understand and approve the amortisation profiles of the Contractor's finance arrangements, since this will determine the level of potential termination payments applicable across the life of the Contract.
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3 See Section 28 (Refinancing).
4 See also HMT Guidance "Interest rate and Inflation risks in PFI Transactions" of April 2006, at www.hm-treasury.gov.uk.