Market-based compensation

The third approach, currently in place in UK, is the market value approach. Under this approach, the contract facilitates the lender's right to step-in in the event of private partner default, allowing them either to rescue or to sell the project. If the lenders fail to step-in, the contract envisages compensation on termination based on the market value of the remaining duration of the contract.

In the market-based compensation approach, the lenders are given rights to step-in when the public-sector party has the intention to terminate the contract following the private partner's default. Moreover, the contract encourages lenders to continue the project by themselves or to sell it, e.g. by allowing them to propose remedies for the ailing project or to seek for a new private partner managing themselves the sale of the unexpired term of the contract.

In the case that lenders choose not to step-in or fail to find a suitable new private partner, the public-sector party has the right to re-tender the unexpired term of the contract seeking for a new private partner by itself. The purpose of the contract re-tendering is two-fold: to increase the likelihood that the project continues as a new private partner takes it, and to collect information about the market value of the project that can be used to compute the compensation payable to the defaulting private partner.

For the above purpose to be accomplished, however, there should be a liquid market in the sector where the project develops, i.e. a sufficient number of firms so as to ensure that bids in the contract re-tendering do reflect the fair value of the project. In this regard, the contract should allow the parties, especially the public-sector party and the lenders, to agree whether the market is liquid or not at the time the early contract termination occurs.

If a re-tendering is conducted and a new private partner is awarded the unexpired term of the contract, the public-sector party pays the proceeds of the sale to the defaulting private partner as compensation, after deducing all the cost that the private-sector party default imposes on the public-sector party (including the costs of the re-tendering).

On the other hand, if no re-tendering takes place, either because the public-sector party chooses not to conduct it or because the interested parties agree in that the market is not liquid, the public-sector party pays compensation to the defaulting private partner using public funds. To compute such compensation, it is advised to use standard market valuation procedures, so that the compensation amount is a reasonable approximation to the market value that would have arisen from a re-tendering had the re-tendering be conducted. Alternatively, the public-sector party could appoint an independent financial expert to determine the value of the remaining project.

The problem with the market value approach is that it might lead to an excessive compensation being payable to the private partner in default, especially if the new private partner is more efficient than the existing one and so can pay a decent price for the contract. A compensation that is equal to the full market value of the remaining duration of the contract (net of the costs imposed by the private partner default on the public sector) could result in the private-sector party bearing minimal losses for its failed performance. Therefore, it might be preferable to include in the contract a formula that establishes how to compute the compensation for the private-sector party and that ensures the compensation is a fraction of the full market value.

Furthermore, private partner default may occur not just because the private partner is inefficient but also because the contract was ill designed (e.g. the risk allocation was inefficient) and the parties did not realize it in advance, or because new circumstances have unfolded and made the contract inadequate. In all these circumstances, re-tendering of the unexpired term of the existing contract is suboptimal and it is unclear why parties should rely on market value in determining compensation payments.

How to design termination clauses is an issue that has been highly debated in the economics literature, which has focused on two main issues:

(i)  how termination clauses can help to ensure that there is an efficient partnership dissolution, i.e. clauses that dissolve the partnership when it is efficient to do so and assign the assets to the partner valuing them the most (see Cramton, Gibbons and Klemperer, 1987), and

(ii)  what is the relationship between the effort (investment) decision made by the partners and the possible termination of the partnership.

Regarding point (ii), some authors have argued that not writing an ex-post efficient termination clause can improve the partnership's performance (Bernheim and Whinston, 1998). The idea is that contracts that contain some 'gaps' (e.g. by not regulating the terms for the break-up) or generate high transaction costs in case of separation (e.g. prescribing joint ownership of assets) may help in establishing the appropriate incentives to cooperate and perform.

In particular, when the contract is silent on some aspects of the parties' obligations, it may be easier for the parties to establish a cooperative partnership. The parties may find it desirable to coordinate as they have an implicit mutual understanding that any breach of the implicit agreement on cooperation by one party will be followed by a similar breach by the other party. The general idea is that it might be beneficial to improve ex-ante efficiency (larger effort/investment) by imposing some inefficiencies ex-post (costly bargaining due to lack of termination clause) that push parties to perform and escape the risk of very costly termination.

However, when it is easy to establish who's default led to termination, the logic above would suggest not to have any compensation for the defaulting party, in order to protect non-contractible cooperative investments undertaken by the well-performing party and to deter bad performance. In other words, most of the value should stay with the party that did not damage the relationship.

An empirical study by Lerner and Malmendier (2004) focuses specifically on partnership termination clauses. They employ a dataset on research agreements between biotech and pharmaceutical companies. Typically, in these alliances the pharmaceutical partner finances the project while the biotech unit carries out the research project. What Lerner and Malmendier show is that when the contribution of the biotech is non-contractible, it is more likely that the initial agreement stipulates that the pharmaceutical firm holds the 'right to terminate'. The basic idea is that the termination right serves to protect the pharmaceutical company from the possible opportunistic behaviour of the partner whose contribution cannot be specified in a binding contract.

The contract should specify the circumstances that may lead the public-sector party and/or the private partner to terminate the contractual relationship before the contract expires. Thus, the contracting parties should agree to specify clauses determining their rights to terminate the contract early. These clauses should describe the reasons that may trigger a contract early termination, and the compensation each party is entitled to when the early termination occurs.

Contract early termination may result from a number of factors, including default of either of both parties, voluntary termination by the public-sector party, force majeure events and corrupt gifts and fraud.

Regarding a public-sector party default, the contract should specify the failures that allow the private-sector party to call for terminating the contractual relationship, making sure that the public-sector party has had the opportunity to remedy the situation.

For instance, the public-sector party may incur in default if it fails to make a due payment after a predetermined period (including interests in arrears), or if it breaches the contract in such a way that it becomes impossible for the private-sector party to perform the service provision during a certain period (e.g. expropriating assets needed in providing the service). Under circumstances like these, the private-sector party should be given the right to terminate the contract early.

In the case of public-sector party default, the public-sector should compensate the private-sector party fully in such a way that the latter bears no financial consequences from the breach. The private-sector party compensation should then be sufficient to cover: (i) the equity return (i.e. the loss of profits over the remaining project term); (ii) the outstanding debt obligations; and (iii) any costs arising from the termination of existing contracts between the private-sector party and its employees and suppliers (e.g. redundancy costs).

The private-sector party should be required to submit a method to calculate compensations at the bidding stage, and that method should be applied if a public-sector party default eventually occurs.75 Further, provisions should be made to ensure that the losses estimated by the private partner are not artificially inflated.

Of critical importance is the provision specifying what happens to the assets built by the private-sector party, which should aim at minimizing service disruptions. The provision should generally ensure that the project's assets are transferred to the public-sector whilst the private-sector party is fully compensated for the losses.

As far as the private-sector party default is concerned, it is the public-sector party that calls for early contract termination. For instance, the private-sector party may incur in default if it fails to meet a predetermined service commencement date, or alternatively a long-stop date, in an infrastructure project involving construction and operation phases.

There may be also a default when the private partner persistently fails to comply with certain obligations such as service performance standards, despite of warning notices and rectification periods allowed to remedy the failures (whilst still imposing deductions). Failure to contract the required insurance and outright private-sector party insolvency may also lead to private-sector party default.76 In general, the contract should specify the circumstances that give the public-sector party the right to terminate the contract early.

The public-sector should enforce deductions and call for a termination of the contractual relationship whenever the conditions for deductions and for termination arise. Failure to impose deductions and to call for contract termination not only destroys the incentives for the current private partner to perform and meet the contractual obligations but it also damages the reputation of the public-sector party with future private partners, which in turn weakens the incentives of these other them.

In the case of private-sector party default, it is recommended to entitle the public-sector party to have the project's assets transferred to it. But to avoid benefiting the public-sector party at the expense of the private-sector party by transferring valuable assets, the contract should also envisage a compensation for the later paid by the former.

In addition, to avoid the costs for the public-sector party associated with terminating the project and interrupting the service provision, it is convenient that the contract includes procedures to facilitate the continuation of the project, e.g. transferring the project to the lenders or to a new private partner.

The contract should envisage a scheme to address the issues of determining the compensation amount and facilitating project continuation. In the companion paper we discuss three possible alternatives: (i) No compensation, (ii) Stage-based compensation, and (iii) Market based compensation, and the benefits and costs of each of them. Depending on the project circumstances, the availability or not for a liquid market in the sector where the project develops, the cost of re-tendering and the presence of alternative private partners, the appropriate approach should be chosen.

It should however be taken into account that approach (iii), currently used in the UK, might not be appropriate in other countries as it might result in a private sector in default receiving an unduly high compensation. In countries where the private sector has had weak incentives to perform so far, approaches such (i) or (ii) can help to provide stronger incentives for the private party and to increase the credibility of the public-sector party.

The contract should envisage circumstances under which the public-sector party has the right to voluntary terminate the contract early. For instance, changes in policy at national or regional level may create restrictions hindering the continuity of a project or making the service provision redundant, and then the public sector may prefer an outright project discontinuation.

In the event of a voluntary early contract termination, the private-sector party should be fully compensated, receiving a payment that leaves it in the position it would have been in had the contract not be terminated. It is recommended to set the same compensation amount payable to the private-sector party in early contract terminations triggered either by the public-sector party's default or by it exercising the right of voluntary termination. This is because, otherwise, the public sector could face distorted incentives regarding the means by which it is entitled to terminate the contract early. In any case, since the private-sector party is being fully compensated, the project's assets should revert to the public-sector party as this will help minimizing service disruptions.

Contract clauses addressing force majeure events should carefully define which events are to be considered as such, e.g. natural catastrophes, acute social conflicts, war or terrorism in the jurisdiction where the projects develops. Under such circumstances, the contract should not entitle any party to claim for a breach of contract by the other party or to impose charges on that party. On the contrary, the contract should encourage both parties to seek for means to mitigate the effects of the force majeure events and to ensure project continuation. Since it may happen that the contracting parties fail to agree on how to deal with these events, it is recommended to give the right to early contract terminate to both of them. Then, in determining compensations applicable to early contract termination on force majeure events, the negotiation between the contracting parties should be based on the principle that force majeure events are the fault of neither party, and that financial damages should be shared. It is advisable to entitle the public-sector party to have the project's assets transferred to it. In addition, the private-sector party should be partially compensated by a payment covering the equity return (party), the outstanding debt obligations, and a fraction of the costs arising from the termination of existing contracts between the private-sector party and its employees and suppliers (e.g. redundancy costs).

The contract should consider corrupted gifts and fraud as causes for early contract termination. In addressing this issue, it is advisable to take into account both the interest of the public-sector party in ceasing the contractual relationship with a corrupted and/or fraudulent partner, and the interest of the lenders, who may not be involved in any prohibited act, in recovering their funding to the project. The contract should specify which actions imply corrupted gifts and fraud. If the private-sector party is directly responsible for a prohibited action, the public-sector party should have the right to terminate the contract by paying the outstanding financial liabilities; in addition, the public-sector party should be compensated by the private-sector party and receive the project's assets. Instead, if the private-sector party is not directly responsible (e.g. the prohibited action is undertaken by an employee acting on his own), it should be given an opportunity to displace the responsible person and then continue the contractual relationship with the public-sector party.

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75  Regarding the equity return, for instance, three methods have been proposed to compute the compensation: (i) a compensation based on the internal rate of return level set out in the original 'base case' (i.e. in the financial model agreed by the contracting parties in order to compute the service charge) for the whole life of the contract; (ii) a compensation based on the market value of equity for the entire duration of the contract; and (iii) a compensation based on the rate of return level set out in the original 'base case' for the remaining life of the contract starting from the early termination date.

76  Early termination on private-sector party default could also happen when the private-sector party requires protection from a court against possible bankruptcy actions undertaken by lenders, as provided for by an administration order in the UK bankruptcy law or Chapter 11 in the US bankruptcy law.