In order to preserve service performance, ensure service continuation, and protect the value of investments, the contract normally includes step-in right clauses entitling the public-sector party and the lenders to take responsibility in specified circumstances over the decision-making that would have been under the private-sector party's control had the times be normal. The HM Treasury (2007) deals with the issue of step-in rights in detail. The recommendation is that the step-in clauses should identify the circumstances under which some party can step-in, and the compensation the parties are entitled to.
Regarding the public-sector party step-in rights, the contractual provisions allow the public partner to take over the private partner's obligations in the project for a period. These provisions differ from early contract termination clauses in that they apply to situations where the public-sector party is supposed to have advantages to deal with certain types of problems. Typically, the public sector executes the step-in rights as a matter of urgency to remedy a serious short-term problem, such as a safety risk, a health issue, or an environmental issue.
To determine who bears the costs arising from the step-in action, it is important to distinguish whether the problem triggering the step-in by the public sector is caused by a private sector breach of contract or not. In the case where the problem is not caused by a breach of contract by the private-sector party, the cost of stepping-in should be borne by the public-sector party in order to induce the latter to internalize the cost of its actions. When instead a private sector breach of contract is the cause of the problem, the costs of stepping-in should be borne by it, e.g. by setting deductions against tariffs or unitary payments.
In a DBFO contract where the private-sector party finances the project upfront, the lenders of the private-sector party may also be entitled to step-in. In fact, it is often argued that the possibility for the lenders to intervene directly in the project management is one of the advantages of using private finance. In PPP contracts, providers of finance look to the cash flow of the project as the source of funds for repayments. Financial security against the SPV is rather limited since the SPV has minimal assets. The facilities often do not have a capital worth in terms of a wide market to which the lenders would wish to attribute values. Moreover, in many cases, lenders have no right to sell the project's assets if the contract terminates. Lenders, therefore, have strong incentives to analyze the project's risks and to monitor the private partner's performance in carrying out the activities assigned by the contract. In this regard, lenders step-in rights allow them to intervene directly in the project management as a means for protecting their invested funds.
This monitoring rule exercised by lenders can then alleviate asymmetric information problems between the public and private partners that arise because the private-sector party has better information on the likelihood of project failure due to private partner's default. In particular, the availability of private finance becomes the means through which the private information of the lender as to the riskiness of the project is credibly transmitted to the public-sector party. The argument is similar to the one made in the economics literature on trade credit to explain how the availability of trade credit can help to alleviate asymmetric information problems between banks and firms that can preclude financing of valuable projects (Biais and Gollier, 1997).74
The nature and aim of the lenders' step-in rights is different from the public-sector party's: while the public sector may step-in to cope with a short-term problem, the lenders may step-in when there is a risk of early contract termination for private sector default. If the public-sector party threatens to terminate the contract early following an event of private sector default, the lenders may be at risk of loosing the funds invested in the project. Under this circumstance, step-in rights allow lenders to substitute the private partner or to replace it by a new private partner in an attempt to keep on the project and get their financial claims repaid.
To the extent that a lenders step-in action may revive the project and avoid service disruptions, the lenders step-in provisions seem to be advantageous for both lenders and the public-sector party. In fact, a direct agreement between lenders and the public-sector party is usually required prior to any lenders step-in right being exercised. In this agreement, both parties settle the service conditions to be applied and acknowledge that the project's benefits will be assigned to debt repayment.
As we have discussed in the companion paper, there may be circumstances under which it is be desirable for the public-sector party and the lenders to take over the responsibilities that the private-sector party has in normal times. Therefore, the contract should include provisions to give step-in rights to the public-sector party and to the lenders. Since the public-sector party and the lenders may wish to intervene in the project under different circumstances, the contract should specify each of them. In addition, the contract should set out the private-sector party's duties and rights when other parties are stepping-in.
It is advisable to establish public-sector party step-in rights to deal with short-term problems involving safety, health, and environmental issues that must be sort out immediately. But in no case the public-sector party should be forced to step in. The contract should contain procedures for the public-sector party to notify the private partner of the motives leading the former to step-in, the date commencing the step-in action, and the expected period in which the step-in action develops.
The contract should contain provisions specifying who bears the cost of step-in. Generally, when the problem triggering the public sector stepping-in does not result from the private-sector party's action, and hence its causes are external to the contract, the costs arising from the step-in action should be borne by the public-sector party. This helps to ensure that the public-sector party has incentives to undertake actions to control these costs.
Further, during the step-in period, it is recommended that the public sector continue paying the private partner for the service as if it were fully delivered. For instance, if the service becomes unavailable as consequence of the step-in action by the public-sector party, unavailability deductions should not apply to payments to the private-sector party.
However, to the extent that some parts of the service are still provided by the private-sector party during the step-in period, payment deductions for poor performance should apply. In the case where payments to the private-sector party are based on service usage and third party revenue, the contract should also include provisions to calculate such payments despite the fact that the service may not be actually delivered.
On the other hand, when a private sector breach of contract causes the problem that leads the public-sector party to step-in, it is the private-sector party that should bear any cost arising from the step-in action. The private sector's failures should trigger the corresponding penalty provisions included in the contract. However, during the step-in period, it is advisable to pay the private-sector party as if it had not breached the contract. If the private sector breach of contract subsists after the public-sector party steps-in, it is recommended to set out provisions allowing for early contract termination on private sector default.
It is advisable to establish lenders step-in rights to encourage lenders to intervene in a project that is at risk of termination on private sector default. The public-sector party should notify the lenders of its intention to terminate the contract, giving them the possibility to step-in in order to revive the ailing project either by managing it by themselves or by replacing the private partner. Similarly to the case of public-sector party step-in rights, lenders should not be obliged to step in. If lenders choose not to exercise their step-in rights, then the public-sector party should be entitled to proceed with the early contract termination, choosing whether to re-tender or not and making the corresponding compensations (see the following sub-section for more details on early termination on private sector default).
On the other hand, if lenders choose to exercise their step-in rights, they should pay for any outstanding liability of the private partner as well as take action to remedy the breaches of contract. In order to give lenders an opportunity to undertake a rectification action, it is recommended to specify a rectification period within which the contract is relieved from termination provisions. In addition, the penalty points accrued prior to the lenders step-in action that may trigger an early contract termination should be suspended as soon as lenders step-in; otherwise, lenders may be reluctant to exercise their step-in rights as there would be a high risk of contract termination arising mainly from the private-sector party's past poor performance.
If the breach of contract arising prior to the lenders step-in action cannot be remedied by the lenders, or if new breaches occur during the lenders step-in period (e.g. outstanding liabilities are not paid by the stepping-in lenders), or if lenders choose to step-out because they no longer wish to revive the project, the public-sector party should maintain its right to terminate the contract early. In particular, the public-sector party should be entitled to proceed with the early contract termination on private sector default as described below.
Case Study: London Underground (UK) (Part VII) The contracts entitled LUL to make deductions from the basic ISC payments when an Infracos' performance fell short of the targets. In addition, the contracts envisaged a number of actions that could be taken by LUL to cope with a persistent underperformance by the Infracos. First, LUL could issue a corrective action notification requiring the Infracos to promptly remedy their poor performance in providing the service, and it could also call for an extraordinary contract review introducing the Arbiter into the picture. Second, LUL was entitled with step-in rights allowing it either to intervene in the pledged works to remedy the problems arising from the Infracos' non-compliance or to appoint a third party to work them out. Third, when the breaches of contract by the Infracos were repeated and/or the LUL had stepped-in for over a year, LUL was allowed to enact a mandatory sale of the contract aiming at ensuring continuity in the service provision. In this regard, unlike other PFI contracts in the UK, the lenders are not allowed to sell the contract to other providers in order to protect their investment; according to the House of Commons (2005) report, this led lenders to call for an initial debt guarantee by the public sector, as discussed before. The contracts had provisions for early contract termination that restricted termination to extreme circumstances such as insolvency or fraud. One might ask why LUL didn't step-in and/or terminate the Metronet contract after the apparent PPP failure. It may be argued that LUL has little incentive to follow such a course of action because, if LUL fails to find a new provider within one year after stepping-in, it will become liable for the £ 2 billion debt of Metronet. Sources: |
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74 A similar argument has also been made to rationalize the benefits from extending product liability to the lender in consumer-credit transactions between the consumer, the seller, and the lender (Iossa and Palumbo, 2004).