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Bankability of construction contracts

This article was written by Michael Dew, a Vancouver lawyer who practices civil litigation. Click here for contact information and further details about Michael’s practice. This article provides only information, not legal advice. If you require legal advice you should consult a lawyer. 

Research articles : 
May 9, 2005
Douglas Sanders, P.Eng., LL.B.
Michael Dew, Articled Student
This article considers the bankability of construction contracts first in the context of private finance initiative (PFI) projects (also called P3 or PPP projects), and second in the context of traditional construction project arrangements.
A bankable contract is one with terms acceptable to the lender financing one of the project participants. Bankability is used to describe not only the contract between the lender and borrower, but all of the contracts on the project. Bankability is an issue when the borrower does not have sufficient assets to secure a loan from the lender. If the borrower had sufficient assets, the lender would simply take security on that property.
Bankability is achieved when the lender is satisfied that the project will be successful such that the borrower will profit from the project and be able to repay the loan plus interest, and when the lender is satisfied that the contractual allocation of risk between the project parties is such that, even if difficulties are encountered, the debt will be protected so far as reasonably possible. 
Most of this article is devoted to discussion of bankability in the context of PFI projects. However, the same bankability principles are generally applicable to project financing within a traditional project structure. In fact, the analysis performed by PFI lenders is the same analysis that has been performed for many years by bonding companies on their constructors with one major exception: the principal asset of a PFI project is the concession rather than any hard assets.
The nature of the principal asset in a PFI project, an assured flow of funds under the concession agreement, means that any risk to that flow of funds places the lender in jeopardy. Public entities, when faced with this question, will generally indicate that they are in favour of a balancing of risks with the party best able to accept a risk taking that risk. However, the same public entity then sells the PFI nature of the project to the public on the basis that all of the risk has been shifted to the project company. It is not possible to have an optimal sharing of risk and cost certainty. A bankable construction contract is one where the public entity bears some of the risk.
In PFI projects, the lender finances the project company. However, bankability is used to describe not only the contract between the lender and the project company, but all of the contracts between the key project participants. The success of the project, and the ability of the project company to repay the debt, will depend on the allocation of risk between all of the project parties. Hence, the lender will have specific preferences for risk allocation between each of those parties. 
The typical structure of PFI projects is illustrated in the sketch below.

Public entity
Project company
DB contractor
O&M Contractor
Bonding Co.
Bonding Co.
The contract between the Public Entity and the Project Company is called the Concession Agreement.
PFI projects typically involve the development of infrastructure desired by a public entity. The public entity will enter into a concession agreement with a project company who is responsible for the design, construction, and initial operation of the project before handing it over to the offtaker at the end of the operation period.
Clearly both the project company and the lender desire project success, but the sponsors forming the project company are equity investors and on successful projects equity investors will make approximately double the gains of the lender: E.R. Yescombe, Principles of Project Finance (Academic Press: California) 2002, at 139 (“Yescombe”). Given the lower potential rewards, the lender will be more risk averse than the project company. Because the lender margins are relatively low and its financial contribution significant, the lender will insist on various measures to protect the debt. Lender desire for certainty is the golden thread that connects the various requirements which make construction contracts bankable.
In addition to influencing project contracts to which the lender is not privy, the lender will also enter into direct agreements with the EPC and O&M contractors, the offtaker, input suppliers, host governments and other key project parties. Under these direct agreements, to which the project company is also party, the lender has the right to “step in” and assume the management role normally performed by the project company. These step in rights give the lender the ability to rectify default by the project company and ensure the proper management of the project, thereby protecting, or at least minimizing the loss to, its debt. 
Generally the lender will want to minimise the risk borne by the project company. The lender will require equity financing from the sponsors in the order of 20-40% and may seek personal guarantees from the individual sponsors: Malleson Stephen Jaques, Bankability of Projects, Asian Projects and Construction update (December 6, 2003):
Furthermore, lenders will require expenditure of equity funds before debt is extended and the lender will not permit sponsors to begin recovering on their investment until debt servicing has begun.
Bankability of PFI projects must be considered at both the pre-contract and post-contract phases of the project. Lenders have specific interests at each of these phases and if the interests are not addressed financing may not be obtained.
Commercial viability – will the project work and make money?
Obviously lenders will only finance projects which are commercially viable; will the project work, and will it make money? There are many aspects to assessment of commercial viability including the following:
o       Is there a sound market for the project or service?
o       How will current and future competition affect the viability of the project?
o       How are the running costs expected to escalate?
o       How reliable is the supporting infrastructure (e.g. the roads leading to the bridge which the project will construct)? Is a guarantee available from the public entity?
o       How reliable are the input supplies (e.g. fuel), and are alternatives available?
o       Does the project company have the resources and skills to successfully implement and manage the project?
o       Is the technology which will be implemented established and reliable or is it innovative and uncertain? Conversely, will the technology soon become obsolete (i.e. information technology projects)?
Risk allocation feasibility
During the pre-contract phase, the lender must consider whether the project subject matter lends itself to risk allocation away from the project company being financed. Risk allocation issues will be considered in detail in the post-contract discussion below, but at the feasibility stage the lender must consider questions such as:
o       Will there be excessive risk which cannot be flowed to the EPC and the O&M contractors?
o       Can liquidated damages be specified for default by the EPC and the O&M contractors, or will such clauses appear to be illegal penalty clauses?
o       What is the probability of default by the offtaker, and can this risk be mitigated?
o       What level of bonding and insurance is available to shift risk to third parties?
o       What liability limitations will the EPC and O&M contractors insist on?
Debt : Equity Ratio
Project finance systems are premised on a high debt : equity ratio. The level of debt which can be raised depends on the nature of the project. The greater the level of certainty of revenue to cover the debt, the higher the debt : equity ratio that will be acceptable to lenders. Conversely, in developing countries and projects aimed at volatile markets, lenders will demand lower ratios.
Typical ratios are (Yescombe at 285):
o       90:10 for infrastructure projects with a project agreement with no usage risk e.g. a public hospital.
o       85:15 for a power or process plant projects with an offtake contracts.
o       80:20 for an infrastructure projects with usage risk e.g. a public transport system.
o       70:30 for a natural resources projects.
o       50:50 for a merchant power plant project with no offtake contract or price hedging.
Who is the public entity - do they have authority?
A number of issues arise in relation to the nature of the public entity entering into the concession agreement with the project company. First, the lender must be satisfied that the public entity has statutory authority to enter into the agreement and has authority to grant the concessions described in the concession agreement. Second, the principle of parliamentary supremacy means that future governments may unilaterally modify the terms of the concession agreement. 
In many PFI projects, one of the areas of greatest uncertainty is the stability and assurance of payment by government. In most Canadian provinces, financial administration is based on yearly allocations of funding which cannot generally be guaranteed. Banks must get to a level of comfort in respect of this issue to lend into Canadian PFI projects.
Pre-contract process
Lenders will have specific interests at each of the three stages of the pre-contract process: Request for Qualifications (RFQ), Request for Proposals (RFP) and Preferred Proponent.
Request for qualifications (RFQ)
The EPC contractor is a vital player in PFI projects and lenders will want to be confident in the capabilities of the EPC contractor. Lenders will desire a suitably experienced and credit worthy EPC contractor.
Bonding or provision of a letter of credit in support of the EPC contractor provides some security, but since the EPC contract sum is typically in the range of 60-75% of the contract sum, a bond covering the EPC contract sum will likely not be sufficient to secure the debt and therefore the overall creditworthiness of the EPC contractor is important.
Lenders will want to review the potential EPC contractors and their respective major subcontractors. Although construction is the task of the EPC contractor, lenders will require evidence of adequate design and project management skills from the EPC contractor.
Lenders will be wary of conflicts of interest that arise when the EPC contractor is also a project sponsor. This conflict can be mitigated by co-sponsors negotiating the construction sum and monitoring EPC contractor performance (i.e. the sponsorship and EPC roles of the EPC contractor must be separated).
Lenders may be uncomfortable with an EPC contractor that relies heavily on subcontractors and may prefer the EPC contractor to undertake a joint venture with companies that might otherwise have been subcontractors.
Request for Proposals (RFP)
The bank will have its own technical advisor review the EPC contract price. Excessively high or low prices threaten commercial viability: higher costs narrow profit margins and low construction sums increase risk of EPC contractor default. Lenders will be particularly wary of high prices where the EPC contractor is also a sponsor because of the conflict of interest described above.
If the project constitutes more than 10% of the EPC contractor’s total annual turnover then there is a risk that project difficulties will compromise the overall financial position of the EPC company. In such cases, lenders may prefer the EPC contractor to form a joint venture with other contractors who also have independent business interests thereby providing financial stability to the EPC companies.
Preferred proponent stage
Lenders desire a streamlined process in which the contractor can present a proposal in a format that suits their preferred implementation scheme. Contractors should be allowed to innovate to reduce costs and implement a work plan that suits their production style. While it is an enviable goal for the public entity to make a decision on its preferred proponent based on 3 or more proposals based on the same, written in stone, concession agreement, this reduces the ability of the proponents to innovate.
One of the disincentives to proponents in PFI projects is the increasing costs of preparing a response. Technical, financial, and legal resource commitments to projects often involve a significant expenditure of time and money with no guaranteed results. The have been some PFI projects that have had few or no potential proponents because of the process costs. It is important to balance the benefit of having what is viewed as an open and fair process, against the significant impediment imposed by process costs and the loss of one of PFI’s highly touted benefits, innovation.
Once an EPC contractor has been selected and project contracts are being developed, various requirements must be met to satisfy the lender and ensure bankability. The lender’s primary interest is to have the principle paid back with interest. Assuming a finding of commercial viability in the pre-contract stage, the likelihood of debt recovery in the event of project difficulties will depend on the allocation of risk between the project parties. 
Generally, the lender will want to minimise the risk borne by the project company. Therefore, the obligations imposed on the project company by the concession contract should be flowed down to the EPC and O&M contractors. Accordingly these contractors should be responsible for timely completion, quality and performance of the project. Liquidated damages should be specified for failure to deliver the project as specified. Difficulties arise when project failure consequences are not easily quantifiable or financially measurable (e.g. what is the cost to the public entity when a toll road is completed late?) In such cases, the liquidated damages clauses may appear to be penalty clauses prohibited by law.
Because of the time value of money, any delay in the project that causes a delay in the repayment of the debt reduces lender cover ratios and increases financing costs. Therefore, time is critically important to the lender and special attention must be paid to schedule and potential recovery for delay.
Table 1 analyses various project risks listed alphabetically. The ideal allocation of risk for the lender is given along with the likely allocation of the risk and risk mitigation techniques.  
Lenders prefer to maximise the risk flowed from the project company to the EPC and O&M contractors. However, “gap risk” is that risk which those contractors will not accept, most likely because it is not readily estimable or is uninsurable, and which cannot be assigned to the public entity.
A concession agreement can be made more bankable by optimizing the risk allocation between the parties by assigning to each party the risk that it is best able to bear. The same sort of optimization process that occurs in the design process should occur in the assignment of risks with each party being assigned the risks that:
o       economically impacts that party more
o       it can efficiently mitigate
o       it can transfer to a third party (i.e. an insurer)
o       is within its control.
Table 1 below provides some guidance on the key risk allocation issues in terms of creating a more bank-friendly contract.

Table 1: Allocation of Risk for Bankability.
Lender’s preferred allocation of risk
Likely allocation of the risk and mitigation techniques
Change in law.
Public entity, and EPC and O&M contractor.
The EPC contractor may be able to obtain political risk insurance. However, the public entity should bear some risk of change in law. The concession agreement should provide some relief for changes in law.
However, changes in law of general application (i.e. income tax changes) are to be borne by the project company.
Cost overruns.
EPC and O&M contractors by way of fixed price contracts.
Increase in debt with no increase in profit reduces cover ratios. Therefore, lenders will be reluctant to extend additional funds. Sponsors will be reluctant to extend additional funds because it will reduce their returns. Hence, accurately estimated fixed price contracts are important. Lenders will generally insist on a contingency reserve to cover construction cost overruns.
Design / warranty / latent defects.
EPC contractor by way of performance and quality guarantees with specified liquidated damages and unlimited liability; O&M contractor after warranty period.
No EPC contractor would provide unlimited performance and quality guarantees. Lenders will accept caps on liability and certain liability exclusions. To ensure project quality, the lender may require approval by the lender’s TA before the EPC contractor’s work is signed off. 
Lenders may demand that liquidated damages be used first to reduce debt and then the remainder distributed to the sponsors to mitigate their reduced returns on equity. 
After the warranty period (which may be longer for latent defects or design issues), the O&M contractor will be expected to take such risk.
Dispute risks.
Dispute risks are not easily assignable, but should be mitigated.
Contracts which clearly define the rights and obligations of the respective parties are essential to avoiding disputes. The contracts should also explicitly set out the dispute resolution processes and require the parties to proceed with the project after giving notice of the dispute.
EPC contractor or public entity.
The EPC contract should require the EPC contractor to comply with local environmental standards and also with the standards of any public lenders (e.g. World Bank) if their standards are stricter. The EPC contractor will not take responsibility for changes of environmental law or unexpected pre-existing environmental threats on site. See “Change of Law” above and “Site Conditions” below.
EPC contractor default.
EPC contractor and its bonding agent.
Because the EPC contract sum is typically 60-75% of the debt extended by the lender to the project company, the bank bond will not cover the full debt. The lender will want to ensure that only competent, credit-worthy EPC contractors are considered during the pre-contract stage.
Force majeure incl. war, civil disobedience, acts of god.
Public entity, and EPC and O&M contractors.
The contracts should carefully and completely define force majeure events and should permit significant relief (both time and money) for events outside the reasonable control of the project participants. As between the EPC and O&M contractors and the project company, insurance should be used to the extent possible. Uninsurable losses (such as economic losses flowing from delay, physical damage from nuclear explosion etc.) will be allocated by negotiation but the lender will usually accept some of these risks.
Input supplier default.
O&M contractor or the input supplier.
See “Third party default” below.
Input demand below input supply contract minimums.
O&M contractor or the input supplier.
Input contracts (e.g. fuel supply contracts) should have provisions to allow reduced supply following specified force majeure events. The lender will want these force majeure events broadly specified, but this may risk the supply if the supplier has equal option to reduce supply on occurrence of the force majeure events.
Offtaker default.
Offtake contract provisions will depend on the nature of the project. If the product can be sold on the free market, the offtake provisions will be less important than if the offtaker is the only possible recipient of the project after the operation period. A “take or pay” clause may require the offtaker to pay for the product even if they decline delivery. If the project yields products that the offtaker declines to accept, the offtaker should be required to pay for storage and other consequential costs, although the project company will be required to mitigate such costs.
EPC contractor, O&M contractor, and public entity
O&M contractor remuneration should be linked to performance with liquidated damages if performance targets are not met.
If the EPC contractor installs new technology, long term performance guarantees may be required i.e. longer than the 2-3 year (Yescombe at 156) warranties normally provided. Lenders are generally wary of new technology because of difficulties in determining causation of problems (i.e. poor design for which EPC contractor is liable or faulty operation by O&M contractor). The public entity will have to take some risk of operational cost increases, generally through escalator provisions.
Permits (Risk of obtaining).
EPC contractor, public entity via government support agreement.
The lender may require permits to be obtained by the public entity or EPC contractor before advancing funds, although for ongoing operational permits this is not possible.
Project company default before the project is operational.
The lender will require the project company to use equity funds first to maximise the incentive for the project company to complete the project once debt has been extended.
The lender may require indemnity from the sponsors personally. The lender can also exercise its step in rights under the direct agreements to take control of the project when project company performance is inadequate.
Project company default when the project is already operating.
Offtaker, Sponsors.
If the offtaker takes early control of the project they should pay a termination sum. This sum may or may not cover the full debt and should be calculated by a pre-determined termination formulae which accounts for the cost of remedying the default of the project company. 
Personal indemnities from sponsors may be required. 
The lender can also exercise its step in rights under the direct agreements to take control of the project when the project company defaults.
Project revenue
Public entity, project company
In some cases, the concession payment is based on usage (e.g. a toll road). If usage is below expectation, there should be some sharing of this risk.
Public entity default, termination of concession agreement.
Public entity.
Termination payment of debt and interest should be specified in the concession agreement, although it is generally difficult to get the public entity to make such payment in the event of termination for default. Separate clauses will be required in the concession contract to protect the lender and the project company, both of whom are at risk of default by the public entity.
EPC contractor by way of a fixed completion date with liquidated damages and limited provisions for extensions of time.  
EPC contractors will demand time extensions due to events whose risk they do not bear (e.g. certain force majeure events). However, no extensions will be allowed for foreseeable events such as bad winter weather.
If a delay in commencement of the EPC contract is possible, a price adjustment formulae based on the consumer price index should be negotiated to provide the lender with certainty of cost escalation. During construction, the lender’s TA and project company should both monitor critical path progress. Third parties such as input suppliers or connecting infrastructure developers may control project process. The third party contracts should put the liability for delay on the third party. See “Third party default” below.
Public entity, and EPC and O&M contractors.
Lenders are very uncomfortable with any ability of the public entity to reduce monthly payments below debt service (including interest). The concession agreement should not permit set-offs to reduce payments below debt service and should where necessary, pro-rate set-offs over enough time to avoid this happening.
Site acquisition and access
Public entity. 
The public entity with its expropriation powers is the obvious bearer of this risk.
Site conditions – geotechnical
EPC contractor
The EPC contractor will generally accept some risk of unforeseen geotechnical conditions. The remainder of the risk will be a gap risk borne by the project company.
Site conditions –Environmental.
EPC contractor, public entity.
The EPC contractor will generally not accept risk of extra costs due to hidden pollution or hazardous waste. If the public entity will not bear this risk, it will be a gap risk that the project company will have to bear.
Site history research and preparatory testing are informative, but do not guarantee that such environmental costs will not be incurred. Furthermore, for extensive site areas typical in road or pipeline projects extensive testing and research may not be feasible. Lenders can mitigate this risk by requiring the expenditure of equity funds first in the hope that such problems will be encountered early in the project before debt is extended.
Canadian legislation extends liability to lenders for environmental pollution on land taken as security. Therefore risk of pre-existing site pollution or hazardous waste is not entirely transferable. Accordingly, lenders may require indemnity from the sponsors.
Site conditions – Fossils or archaeological remains.
EPC contractor, public entity.
The EPC contractor will generally not accept risk of delay costs due to the discovery of fossils or archaeological remains. If the public entity will not bear this risk, then it is a gap risk that the project company will have to bear.
Step-In Rights
Public entity.
The lender will require significant lead time on any action by the public entity to set-off, step-in or terminate. Given the length of the concession and the unfamiliarity of lenders with details of a project that has been operating successfully for years, it may be necessary to permit the lender 6 months or more to analyze the situation before the public entity can exercise its rights of step-in etc.
Third party default.
Third parties, public entity.
Project progress may be dependent on third parties such as utilities relocates (e.g. in a road project), adjoining infrastructure developers (e.g. in a hydro electric scheme) input suppliers (e.g. fuel suppliers) etc. The costs of default or delay should be passed on to these third parties as an incentive for proper and timely performance. The risk of some third party interference (e.g. protestors disrupting the EPC contract) may be shifted to the public entity. 
Variations – Changes in specifications.
Public entity.
Design risk lies with the EPC contractor, but this does not cover changes to the scope of the project requested by the public entity. Lender approval will be required for changes to scope of the project and the concession agreement should eliminate the option of changes in scope without re-negotiation. 
The sketch below provides a rough guide to the risks shared by each of the project parties on PFI projects. Actual risk allocation is different in each project and in many cases particular risks will be split so Figure 2 may not be accurate or complete for any given project.
Lenders have specific requirements at both the pre and post-contract stages of PFI projects. Both the pre-contract process and the project contracts must be bankable if lender support is to be secured.
The EPC contract constitutes a large portion of the project cost. Therefore, apart from being satisfied that the project is financially viable, the primary interest of lenders during the pre-contract stage will be to ensure only well qualified credit worthy EPC contractors are considered. 
The primary post-contract interest of lenders is to have the debt properly serviced. Therefore, bankability requires specific contractual allocation of risks. Furthermore, lenders will generally require that the equity funds be exhausted before debt is further extended so that unexpected difficulties encountered early in the project do not threaten lender funds.
Lenders provide most of the financing and stand to make lesser returns than the equity investors. Therefore, lenders are risk averse and use their strong bargaining position to delegate risk and maximise the probability of proper debt servicing even in the event of project difficulties.
The bankability principles discussed above in relation to PFI projects can be applied to projects structured in the traditional way i.e. projects in which the owner has a contract with a main contractor who implements the design of the owner’s design professionals. As illustrated in the sketch below, lenders may assist either the owner or the contractor:

Design Professionals
Bonding Company
Bankability issues will arise when the borrowing party does not have sufficient assets to secure the loan. Instead the lender will rely on borrower successfully recovering income from the project to service the debt. Accordingly the lender will be concerned to ensure the project will be successful and will desire specific risk allocations between the project parties to protect the debt even in the face of project difficulties.
There are common and conflicting interests between the lender financing the owner and the lender financing the contractor. While both want the project to succeed, each would like to shift as much risk as possible to the opposing party.
The role of the party scrutinizing the viability of the project and the economics of the contractor in traditional projects is filled by the bonding company. All of the comments above in respect of lenders and their analysis in respect of the project are applicable to bonding companies. Hence, for a traditional project to attract bondable companies, the construction contract must be structured so as to permit success by the contractor.
Cover ratios = Ratios of the cash flows from the project against debt service.
Debt service = Payment of principle and interest instalments.
Debt Servicing = Repayment of principle and interest.
EPC = Engineering, procurement, construction management; can also be described as Design Builders
Lender = Bank who finances one of the project parties.
O&M = Operate and maintenance
Offtake contract = The contract under which the project company sells the project to the Offtaker. This contract is finalised at the project initiation stage.
P3 = Public Private Partnerships (Analogous to “PRI”).
PFI = Private Finance Initiative (Analogous to “P3”).
Project company = Consortium of sponsors who manage and control the project
Sponsors = Investors who develop and lead the project through their investment in the project company.
TA = Technical Advisor