Public private partnership is a widely used model when it comes to infrastructure financing. However, it needs to be understood that not all public private partnerships end successfully. In some cases, the partnership ends in a default. This means that either one of the parties’ viz. the private party or the public party are unable to meet their contractual obligations. In such a situation, the counterparty can ask for the termination of the contract. Provisions which may apply in the event of the early termination of a contract are often mentioned within the contract itself.

In this article, we will study some of the possible default scenarios as well as the events which commonly follow an early termination.

Types of Early Termination

Early termination can be classified on the basis of two parameters. One of the parameters involved is the stage of the project when the contract is being terminated. The other parameter is the party which is initiating the termination of the contract. This classification has been explained in detail in the article below.

1. Termination of Convenience: Termination of convenience means that the government party is unilaterally terminating the contract without any party actually being in default. This means that both the private as well as the public partners are in full compliance of their duties. However, due to a change in government policies, the public private partnership may no longer be required.

   In such cases, the government is supposed to ensure that the interests of the private parties are not compromised. This means that all the money invested by the private party has to be returned by the government. In addition to the government has to pay an internal rate of return on the investment which was decided before the project actually started. The problem is that the government is supposed to only make payments as per the project schedule. Hence, if a project team has done extremely well and has beaten project deadlines, they are not going to be rewarded for the same. Instead, it is likely that they will be penalized since they may not receive the differential payment.

   Such policies are not usually followed by any government across the world. However, the infrastructure company needs to make sure that the contract is drawn up in such a way that termination of convenience doesn’t remain a convenient option. This type of early termination can happen at any stage of the project.

2. Default by Public Party: In many cases, the government party goes bankrupt. As a result, they are not able to make periodic payment to private parties for execution of the project. In such situations, private parties have the right to stop the execution of the project and demand payment. Depending upon the manner in which the project has been drawn, the public party may also have to compensate the private party for the opportunity costs of the project as well. In many cases, if the government is not able to pay the private party, they may provide outright ownership to them. The private party can then sell the asset to recover their dues. Alternatively, they can keep the ownership of the assets and can benefit from the cash flows that accrue from them.

   It is important for the project to first be valuated before any of these steps are taken. Valuation can be done based on the book value or the market value. The market value of an unfinished project is difficult to determine. Hence, a lot of times, these compensations are based on the book value. In some cases, the government is forced to at least pay down the loans which are outstanding on the project. However, if lenders have a guarantee of being paid, they are left with incentive to measure the progress of the project. This is why a lot of contracts make it mandatory for the debt partners to take a hair-cut so that they are not able to benefit at the expense of the equity partners.

3. Default by Private Party: Default by governments is a rare event. However, default by private parties is much more common. A lot of times private parties are not able to adhere to the project schedule. In such scenarios, the government is supposed to give them a warning. However, even after repeated warnings, if a private party is unable to deliver, then their services may be terminated. The government should make an attempt to find the root cause of the problem. If the root cause is related to subcontractor, additional time must be given to the private party so that the problem can be sorted out. If the private party is still unable to deliver, then their services must be terminated. The government may levy additional fines and penalties on the private party since finding a replacement contractor may be difficult.

4. Force Majeure: In many cases, acts of God make it impossible to execute a project. In such events, either parties can cause an early termination of the contract, if they so desire. The prudent approach is to ensure that the risks in these cases are divided between the two parties. In most cases, governments agree to provide the principal which has been invested by the private companies into the project. This means that the private companies earn an IRR of 0% whereas the government loses the sum of money which has been paid.

The above instances clearly show that the termination of contracts prior to their maturity is expensive for all the parties involved.