Direct agreements help protect lenders
MARTIN PRESTON* takes a look at the main features of direct agreements and how they help safeguard the interests of lenders of any projects, in case of termination of project contract.
01 June 2010
IN a project finance transaction, when deciding whether or not to advance funds to a project, lenders assess the revenue arising under the contracts entered into with the project company and the strength of the covenants contained within them. And since the lenders’ main security is the project contracts themselves, it follows that the continuity of those contracts is of fundamental importance to them.
Consequently, a feature of any project finance transaction – be it a PFI (private financed initiative)/PPP (public-private partnership)-based infrastructure project, a power station, or a process plant – is the provision of direct agreements by the counterparties to the project contracts (the subcontractors) in favour of the lenders. The main features of direct agreements are:
No termination without consent
The direct agreement will require the relevant subcontractors to notify the lenders prior to terminating their project contract for project company default, and their right to terminate that project contract will be suspended while the lenders decide what action to take.
Although it may appear unreasonable for a party to give up or restrict its right to terminate a contract for breach by the other party, this arrangement may ultimately lead to the project company’s default being cured and be to the advantage of the subcontractors.
Notwithstanding this, subcontractors will be concerned about the length of time that their rights to terminate can be suspended and what their obligations would be during this period – that is, if they are required to perform all their obligations; are they entitled to suspend performance until the lenders have made their decision; or are they required to perform for part of the suspension period, with an option on the lenders to require them to perform for the remainder of the suspension period by paying them all or a part of their costs of doing so? This is one area where the direct agreement will be keenly negotiated by both the lenders and the subcontractors.
Lenders’ right to step in
Should they decide to do so before the end of the suspension period, the lenders or their nominee (usually termed an additional obligor) will be entitled to step in and take control of the project for a given period (the step-in period). The additional obligor will be jointly and severally liable with the project company for the latter’s obligations during the step-in period. However, the reality is that, during the step-in period, the additional obligor will take control of the project and make payment to the subcontractors for the obligations they carry out during that period (see also reference to relevant liabilities below).
Lenders’ right to step-out
If the efforts of the additional obligor to save the project are unsuccessful, it will have the option to step out and walk away from the project either by giving notice to the subcontractors or by failing to novate the project contract to a third party before the expiry of the step-in period. If this occurs, then subject to relevant liabilities (see below), the liability of the additional obligor is limited to payment for the work or services performed by the subcontractors during the step-in period.
Novation
If the additional obligor is successful in getting the project back on track, the project contract will be novated to a third party, who will replace the project company under that contract. It will assume all the unfulfilled obligations of the project company and release the project company and additional obligor from their obligations under the contract and the direct agreement.
One issue for the subcontractors will be the identity of the party to whom the contract is novated. Usually, the direct agreement will only grant very limited rights of objection, such as a lack of financial and/or technical competence to perform the obligations, which are being novated. In certain industry sectors, it may be also be possible for subcontractors to object to the project contract being novated to a competitor.
Relevant liabilities
On giving the lenders notice of its right to terminate the project contract, the subcontractor will also provide the lenders with a statement of amounts that it believes are due to it from the project company (the relevant liabilities). Needless to say, since this involves amounts owed to the subcontractors, it is usually the subject of much debate between the lenders and the subcontractors, largely focusing on two issues:
(a) Should the statement of relevant liabilities be conclusive?
The lenders will argue that it should, on the basis that only the subcontractors have the information required to produce this. The subcontractors will generally seek to resist this on the grounds that they only have a limited period of time in which to produce the statement of relevant liabilities.
(b) When should the relevant liabilities be paid?
The subcontractors will want these amounts to be paid as soon as possible (that is, on a step-in). The lenders, however, will often argue that they should only be paid on a novation and not while the additional obligor is trying to save the project during the step-in period; and that if there is no subsequent novation (that is, there is a step-in and step-out without the relevant liabilities being paid), the subcontractors’ right to payment would be against the project company.
Miscellaneous issues
The lenders’ right to step in will also crystallise on the occurrence of an event of default under the loan agreement and so may not necessarily be triggered by the project company breaching the underlying contract. However, the effect on the various parties under the direct agreement remains substantially the same.
On PFI/PPP projects, where the host government grants a concession agreement to the project company, it may also require direct agreements from the construction contractor and FM (facility management) services provider, enabling it to replace the project company under those contracts if the concession agreement is terminated. The host government’s step-in rights should, in almost all circumstances, be subordinated to those of the banks.
* Martin Preston is a partner in Norton Rose (Middle East) LLP. Legal queries related to the construction sector can be addressed to Norton Rose (Middle East) LLP through Gulf Construction magazine at editor@gulfconstructionworldwide.com.
Norton Rose Group has had a presence in the Middle East for more than 30 years and has advised developers, lenders, and contractors in relation to the legal aspects of a wide variety of construction and infrastructure projects in the region.
With a combined team located in the Bahrain, Abu Dhabi and Dubai offices, Norton Rose (Middle East) LLP is able to provide both contentious and non-contentious support to financiers, developers, contractors and specialist contractors in the region.
