FIDIC MDB HARMONISED CONSTRUCTION CONTRACT CONFERENCE Session 10: Client Perspective Borrowers, private clients, finance issues

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FIDIC MDB HARMONISED CONSTRUCTION CONTRACT
CONFERENCESession 10 Client PerspectiveBorrowe
rs, private clients, finance issues

• Jacques Bouillon
• Partner, White Case LLP
• 26 June 2012

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Introduction to Project FinancingsContractual
Scheme of a Project Finance
3
Role of the Construction Contract in a BOT-
Concession Scheme within a Project Finance
Structure

• In a typical scheme a special purpose vehicle
  (the SPV) has the rights and obligations under
  a concession or a BOT agreement (the
  Concession-BOT Contract) with a public body
  (the Grantor) to design-finance-build and
  operate an infrastructure (1)
• The SPV finances the construction of the
  facilities through loans from banks (4) or the
  capital markets as well as through equity
  investments from its shareholders (5)
• Due to the non-recourse nature of these loans,
  Lenders looks principally to the cash-flow
  generated by the operation of the project (6) -
  and not from the shareholders - as the source of
  funds from which their loans will be repaid
• To satisfy the SPVs obligation to the Grantor to
  design and build the infrastructure, the SPV will
  enter into a construction contract (the EPC
  Contract) (2) with a contractor (the
  Contractor) under such a contract, the
  Contractor will be required to design-build test
  and commission the project on a turnkey basis for
  a fixed lump sum price and within a fixed time
  for completion, guaranteeing a specific quality
  or level of performance for the completed works
• The terms of the EPC Contract will be as far as
  possible back-to-back with the Concession-Bot
  Contract and thus any construction risk placed
  on the SPV by the Concession-BOT Contract will,
  through the construction, flow down to the
  Contractor
• The price paid to the Contractor is usually the
  largest capital expenditure incurred by the SPV
  .and the EPC Contract is usually, the most
  likely source of significant cost overruns.

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Lenders, Shareholders and Grantors expectations
Consequences on the construction Contract

• Shareholders seek to raise money for the
  implementation of a project
• Shareholders expecting a return on equity will
  want to protect their expected returns by placing
  construction risk on the Contractor
• Shareholders also know the more risk they can
  transfer to the Contractor, the less direct or
  indirect support they are likely to be asked to
  provide to the project by Lenders to cover such
  risk (8)
• Any Lender will want to satisfy itself as to the
  expertise and experience of the Contractor and
  check the terms and risk allocation under the EPC
  Contract before committing itself into financing
• The EPC Contract will result in the piece of
  infrastructure that will be relied upon by the
  Grantor during the term of the concession period
  and will be handed over to the Grantor at the end
  of the period
• All these factors will put pressure on the
  Contractor to accept an increasing amount of
  responsibility and construction risk.
• Lenders may be less concerned about having the
  SPV pay a higher construction contract price in
  order to induce the Contractor to accept as much
  construction risks as possible the Shareholders
  (in particular those not affiliated with the
  Contractor) will generally view a higher price as
  reducing their equity return and will be much
  more sensitive to contract pricing

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Focus on the EPC Contract within a Project
Financing Framework

• To evaluate the bankability of a project, the
  Lenders need to be able to assess with a certain
  accuracy the residual risk borne by the SPV (the
  borrower) in fine, i.e. the risk not borne by
  either the Grantor through the Concession-BOT
  Contract or by the co-contracting party through
  the EPC Contract or the OM Contractor under the
  OM Contract (3). Thus, to tend to such certainty
  in a project financing, the construction contract
  is
• Usually a turnkey contract
• a design and build contract
• fully equipped facility delivered, ready for
  operation at the turn of a key (the EPC
  contract)
• lump sum price
• strict construction timetable (damages
  provisions) longstop date
• must be bankable contractor with a good credit
  risk or supported by a creditworthy guarantor.
• A turnkey contract with specific technical
  aspects
• strict definition of the transparency principle
  with the Concession-BOT Contract (back-to-back)
• accurate treatment of the guarantees
• insurances
• payments
• Lenders rights (step-in rights).

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Which FIDIC Standard Forms to Tailor?

• As a consequence, the Silver Book, which was
  originally intended for use in privately funded
  projects such as a turnkey subcontract in
  private-public partnerships (PPP), seems to be a
  more suitable basis to tailor a standard form of
  DB contract within a project financing
  framework, notably for the following reasons
• EPC/Turnkey contract
• Lump sum price
• Allocation of risks more risks borne by the
  Contractor which avoids uncertainty of risks
  borne by the SPV
• The Pink Book (MDB Harmonised Edition), even if
  including specific clauses adapted to
  Multilateral Development Banks, seems less
  suitable, notably as it is not drafted for
  turnkey projects and the SPV is in charge of the
  design (whereas, in the Silver Book as well as in
  a project financing scheme, the Contractor is).

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The Back-to-Back Principle Definition

• Definition of the back-to-back principle
• Complete transparency between (i) the duties and
  obligations of the SPV under the Concession-BOT
  Contract and (ii) the duties and obligations of
  the Contractor under the EPC Contract regarding
  the design and construction aspects (same
  mechanism as the one contemplated in the FIDIC
  book Conditions of Subcontract for Construction).
  
• The back-to-back principle serves the bankability
  of a project as it ensures that, except for those
  which cannot be passed through because of law
  restrictions, all the project risks pass
  through the SPV directly to the most suitable
  co-contracting party to bear it (in the case of
  construction risks, to the Contractor).
• Strict definition of the transparency principle
• Only  if and when 
• Claim mechanism due proportion with payment
  devolved primarily to the Lenders (the Due
  Proportion)
• Documentation hierarchy (i) Concession-BOT
  Contract and (ii) Contractor Direct Agreement
  both prevail on the EPC Contract in case of
  contradiction.

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The Back-to-Back Principle Consequences

• The back-to-back principle reflects on all the
  DB Contract, notably
• Payment of any sum due by the Grantor to the SPV
  for the construction phase under the
  Concession-BOT Contract like subsidies (if any)
  or indemnities
• Back-to-back guarantees bank guarantees (e.g.
  performance guarantee) may be ordered directly by
  the Contractor to the benefit of the Grantor to
  avoid a two-level guarantee unnecessarily
  expensive
• Back-to-back penalties capped and specific
  (e.g. delays, construction phase) allowing a
  more accurate assessment of the maximum risk
  incurred by the SPV (to reflect it on the
  Contractor)
• Force majeure, unforeseen events, change of law
  (same grounds to claim additional time and
  additional money to complete the works than those
  provided for under the Concession-BOT Contract)
• Administrative procedures
• Termination grounds grounds of general interest,
  force majeure, unforeseen event, breach by a
  party, breach by one party leading to the
  termination of the Concession-BOT Contract
• Termination indemnities the SPV will indemnify
  the Contractor only up to the amount it received
  from the Grantor, within the limits of the Due
  Proportion and only once the SPV has actually
  receive the payments from the Grantor.

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Additional Protections within the EPC Contract

• To minimize their exposure, in addition to the
  protections offered by the back-to-back
  principle, the Lenders usually also require
• Additional guarantees
• Construction timetable shorter deadlines for the
  Contractor to perform its obligations so as to
  enable the SPV to comply with its own deadlines
  under the Concession-BOT Contract
• Additional penalties, notably those incurred in
  relation to the Loans
• Example of provision Within the limit of the
  penalty cap, the Concessionaire may apply to the
  Contractor any sum intended to repair damages
  suffered by the Concessionaire as a result of a
  failure to perform or poor performance of the DB
  Contract by the Contractor, and, for example, an
  increase in management costs for the
  Concessionaire and/or late payment interest
  and/or financial costs and/or costs connected
  with adjusting or liquidating interest rate swap
  agreements and/or loss of operation and/or
  indemnities owed to the Operator and/or
  indemnities owed to third parties.
• Specific caps for more accurate assessment of the
  risk borne by the SPV.
• Liability cap, notably adjusted so as to cover
  the remaining amount of the outstanding debt of
  the SPV, not already covered by the indemnity
  paid by the Grantor in case of termination for
  breach of the Concession-BOT Contract.
• Performance deadlines depending on completion (?
  taking-over).

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Lenders Involvement

• Taking into consideration of the Lenders in the
  project documentation and appointment of a
  technical advisor by the Lenders (LTA) to ensure
  there is no management of the project by the
  Lenders but only a technical involvement.
• Illustrations
• LTA
• Validation of (i) technical aspects such as key
  milestones, (ii) payment to the Contractor
• Participation in (i) the meetings, (ii) the
  taking-over process
• Access to the site and information (copy of
  technical documentation, modification, studies)
• Lenders
• No offset by the Contractor of any sum due to
  the SPV with sums due by the SPV to the
  Contractor until Lenders are entirely paid
• In case of termination of the Concession-BOT
  Contract, neither imputable to the Contractor or
  to the SPV (i.e. force majeure), the Lenders have
  to be repaid before the SPV indemnifies the
  Contractor (Subordination principle)
• Agreement by the Lenders to the EPC Contracts
  assignment

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Construction Direct Agreement (7)

• The Construction Direct Agreement, as its name
  implies, organizes the relationship of the
  Contractor directly with the Lenders and the SPV.
  
• It notably contemplates major principles in favor
  of the bankability of a project
• Subordination principle the Contractor, in its
  capacity as creditor towards the SPV, is
  subordinated to the Lenders to be paid.
• Remediation principle the Contractor may not
  suspend or terminate the EPC Contract without
  having notified the Lenders and granted them a
  time extension to decide whether to remedy to the
  SPVs breach or not.
• Substitution principle in case of contractual
  breach by the SPV under the Concession-BOT
  Contract, the Lenders may substitute a new entity
  to the SPV to avoid the termination of the
  project. In this respect, the Contractor
  undertakes to comply with its initial contractual
  obligations towards the new entity as if it was
  the initial SPV.
• Representations and warranties towards the
  Lenders and the SPV, notably in order to avoid
  that its subcontractors compete with the Lenders
  as creditors.

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Interface Agreement (9)

• The Interface Agreement organizes the
  relationship between the SPV, the Contractor and
  the OM Contractor as, during the construction
  phase, the OM Contractor intervenes
• to comment, or validate, design plans and
  documents of the Works
• to assist the SPV during the taking-over process.
• It notably tend to determine which actor assumes
  which tasks, responsibility, indemnity and
  penalty
• Possible fronting the Contractor, during the
  construction phase, assumes in back-to-back the
  penalties potentially applied or the indemnities
  claimed by the Grantor under the Concession-BOT
  Contract. Thus, the SPV do not have to research
  which of the Contractor or the OM Contractor has
  actually caused the breach. And as (i) during the
  construction phase, the Contractor is more likely
  to be causing the contractual breach of the SPV
  under the Concession-BOT Contract and (ii) the
  liability cap of the Contractor is more suitable
  to cover the sums potentially due (higher cap).
• Afterwards, the Contractor may challenge the OM
  Contractor. Sums paid under the fronting do not
  impact the global liability of the Contractor.