Most PPP Projects are financed on a "limited recourse" basis (see Section C, PPP Contracts in Context) under which third party lenders loan funds to the Private Partner based on an analysis of the projected cash flows generated under the PPP Contract.
As the PPP Contract is usually the sole source of revenue (or basis for revenue in the case of "user pay" PPP Contracts) for debt repayment, the prospect of the Contracting Authority terminating for Private Partner default is of significant concern for Lenders, particularly if the termination occurs before the asset has been completed and the service commenced. This is because even where a termination payment will be made by the Contracting Authority, the amount may not cover the entire debt amount and so Lenders are incentivised to get the PPP Contract back on track so that debt can be repaid as scheduled and in full.
One way Lenders seek to protect themselves against termination of the PPP Contract following Private Partner default is to negotiate step in rights. While their validity and enforceability have rarely (if ever) been properly tested in court in any jurisdiction, the formal existence of step in rights gives Lenders comfort in terms of bankability and provides a framework within which the Parties can come together to negotiate solutions in a default/termination scenario, subject to the impact of mandatory law (for example with regard to receivership, bankruptcy and public procurement rules). Step in rights are typically enshrined in an agreement between the Lenders and the Contracting Authority, often called a "Direct Agreement" or, in some jurisdictions, a "Consent Agreement." The Direct Agreement will entitle the Lenders to be alerted to a potential termination and to take steps to prevent it by rectifying the problem. From the Contracting Authority's perspective, its interest in completing the infrastructure and ensuring adequate service provision and the Lenders' interests in achieving the same outcome are aligned. Direct Agreements enable Lenders to engage directly to try to save the PPP Contract before the Contracting Authority has to deal with termination and its consequences.
In a PPP context, direct agreements are executed not only in relation to the PPP Contract but also in relation to the Project Agreements. In the latter case, both the Lenders and the Contracting Authority may have separate direct agreements with the Private Partner's Project Agreement counterparties (i.e. its main sub-contractors) to ensure that the counterparties grant them similar opportunities to rectify defaultsby the Private Partner under the Project Agreements before the counterparties may terminate and also to ensure the counterparties' continued performance.48 This Section 6 focuses on Lenders' step in rights in respect of the PPP Contract.
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48 In terms of order of exercise, the Lenders' rights under their Direct Agreement with a sub-contractor will typically take priority over the Contracting Authority's rights under its Direct Agreement with the same sub-contractor.