State Security - Super Priority to the Construction Account balance?
Depending on the jurisdiction involved, PPP Project Vehicles often secure their assets in favour of both the State and Financiers. In such cases, the Financier-State Direct Deed, among its other usual matters, regulates those parties’ enforcement priority. As would be expected and subject to the below paragraph, the Financiers’ security ranks in priority to the State’s.
An important exception usually exists however which (broadly speaking) super-prioritises to the State, amounts incurred by it in responding to emergencies or other defined circumstances. And being all asset securities, both the State and Financiers’ securities extend to amounts held by the Project Vehicles in their Construction Account (essentially established to hold the cash used to fund construction costs).
Under current market practice (which is often driven by a desire to match drawn funds with interest rate hedging profiles), it is not unusual for all or most of the Construction Facility to be drawn ahead of the date on which the relevant funds would otherwise have been used to actually fund due and payable construction costs. Accordingly, the usual pre-conditions to accessing Construction Facility funds which operate to ensure that only those funds which are necessary for immediate construction spend are made available to the Project Vehicles (and also that sufficient funds remain available to cover forecast remaining construction costs) become:
- tests to withdrawals from the Construction Account (the balance of which is an asset of the Project Vehicles),
- tests to drawdowns from the Construction Facility (where the funds remain cash held to the control of Financiers).
This results in a disjunction with the commercial intent of the parties. Specifically, where construction-related or other events of default are tripped under relevant documents, the parties’ expectation was always that Financiers’ funds which had not yet been applied towards Project construction would be quarantined from both the State and Project Vehicles. Under the described current market practice however, the fact those funds have already been drawn and deposited to the Construction Account means they will now be within the State’s security and, potentially, lost to Financiers if an emergency or other trigger to the State’s super-priority trips and the State incurs commensurate response costs.
From a Financier’s perspective, relatively simple solutions to this ‘de-prioritisation’ risk have been developed and include either:
- expressly removing the balance of the Construction Account (or, as a sub-set of that, the proceeds of any Construction Facility drawings) from the ambit of the State’s super-priority either contractually or structurally; or
- (bearing in mind any impact on the interest-rate hedging arrangements) applying the usual pre-conditions to accessing construction funding at the Construction Facility drawdownstage, rather than at Construction Account withdrawal.
Construction milestones and the look-forward test
In addition to the stipulated target date for project completion, construction contracts also typically stipulate a ‘sunset’ or ‘long-stop’ date. This date is usually the absolute deadline by which construction (by the builder) must be completed.
Project Vehicles are often entitled to engage independent certifiers to assess construction progress and form an independent opinion as to whether completion is likely to be achieved within the required timeframe. Failure to satisfy this ‘look-forward test’, or to achieve completion by the sunset date, usually entitles the Project Vehicles to terminate the construction contract.
Recent market experience evidences potential for increased focus on these regimes by both Sponsors and Financiers. In addition to the usual protections outlined above for example, further protections may be considered or negotiated along the lines of:
- imposing additional milestone obligations on the builder prior to the project completion target date.Repercussions for failure to meet such milestones might include obligations on the parties to liaise with each other and/or with Financiers, and/or the provision of (and compliance with) specific agreed cure plans; and
- entitling the Project Vehicles to terminate the construction contract where the builder fails to comply with an agreed milestone cure plan or achieve a new milestone set out in an agreed cure plan.
The above protections (where adopted) can represent a significant shift in approach to the construction process. As a result, Sponsors and Financiers may find themselves both:
- more actively engaged in the construction process through their direct involvement in such processes and specific express mechanisms; and
- able to step-in at a considerably earlier stage of a construction failure (or potential failure).
Conclusions and further reforms
The underlying driver for increasing focus on construction processes as discussed above in recent deals is an increasing desire of Sponsors, Financiers and Investors alike to more actively manage the construction process and its associated risks. The key outcome sought is often an ability to step-in and ‘rescue’ a project well before delays become critical as between Project Vehicles and the State.
For the time being, we expect the market to consolidate around the issues and solutions described above and possibly undergo further changes as Stakeholders (including governments) re-evaluate construction risk management and allocation in greenfield infrastructure projects. As a case in point on this, PPP reforms were announced by the Victorian government on 2 May 2013 (see Partnerships Victoria Requirements (May 2013)), which are intended to apply to the next generation of Victorian PPP projects. The reforms, if implemented, could result in significant changes to conventional PPP bid process and structuring.