A distressed PFI project is one that faces significant contractual, relationship, and/or financial problems, increasing the risk of early contract termination. The guidance emphasises that project distress often stems from underlying performance issues, which can be exacerbated by poor behaviours among contract parties. If not addressed, these issues can escalate, leading to project company insolvency and contract termination.

The guidance identifies several common causes of project distress:

• Unresolved Contractual Issues: These include construction defects, compliance issues, and service provider performance problems.
• Relationship Breakdown: Poor behaviours and lack of trust between parties can lead to more disputes and greater project distress.
• Project Company Financial Stress: Financial difficulties can arise from large payment deductions, higher than budgeted costs, and other financial pressures.

The IPA recommends a collaborative approach to managing project distress, supported by robust, professional relationships and behaviours. Key strategies include:

• Preparation: Developing a clear legal, commercial, financial, and operational strategy, including both Plan A (resolving the issues) and Plan B (failure to resolve the issues).
• Constructive Dialogue: Setting ground rules for negotiations, involving the right people, and maintaining transparency about the problems facing the project.
• Access to Funding: Ensuring that there is sufficient funding to resolve contractual problems, whether from contractors, service providers, shareholders, lenders, or contracting authorities.

The guidance details the potential consequences of project company insolvency and contract termination, including:

• Operational Disruption: Insolvency proceedings can disrupt service delivery and change contract relations.
• Financial Impact: Contract termination can have serious financial and budgetary consequences for contracting authorities.
• Litigation Risks: Prolonged and costly legal disputes are possible as lenders seek to recover their loans.

The guidance provides a checklist for Senior Responsible Owners (SROs) and senior leaders within contracting authorities to assess and manage project distress. Key steps include:

• Initial Assessment: Gathering relevant information and carrying out a commercial, operational, and financial assessment.
• Strategy Development: Getting good advice, knowing the contract parties, and developing actionable plans for both resolution and non-resolution scenarios.
• Implementation: Developing a business case, reviewing timelines, and getting necessary approvals.

Detailed Steps for Contracting Authorities

Part 1 of the guidance document provides a detailed roadmap for contracting authorities on how to assess, monitor, and manage project distress. Here are the key steps:

Part 2 of the guidance document delves into the financial aspects of PFI project distress, providing insights on how to monitor and manage project company financial stress. Key points include:

Understanding PFI Project Company Structure PFI project companies are typically set up as special purpose vehicles (SPVs) with the sole purpose of delivering the PFI contract. They pass construction and service delivery risks down to subcontractors, but financial issues can still remain at the project company level.

Causes of Financial Stress Financial stress in project companies can arise from various factors, including:

• Service Provider Liability Caps: Payment deductions exceeding service provider liability caps remain at the project company level.
• Construction Liability Periods: Defects and compliance issues arising after the construction contractor's liability period can cause significant financial stress.
• Disputed Deductions: Disputes over payment deductions can leave financial burdens at the project company level.
• Lifecycle Costs: Higher than expected lifecycle costs can impact the project company's financial viability.
• Service Provider Insolvency: Replacing insolvent service providers can be costly and disruptive.

Monitoring Financial Health: Contracting authorities should regularly monitor the financial health of their project companies using various tools:

• Financial Models: Reviewing financial models to assess debt service cover ratios, shareholder payments, and reserve account funding.
• Lender Reports: Obtaining operational and financial reports provided to lenders.
• Report and Accounts: Analysing annual reports and accounts for signs of financial stress.
• External Credit Ratings: Monitoring credit ratings for indications of financial difficulties.

Other Indicators of Financial Stress: Additional signs of financial stress include late payments to service providers, major contractual disputes, unexpected staff changes, large deductions, and waiver requests.

Part 3 of the guidance document provides an in-depth look at project company insolvency, explaining its implications and how contracting authorities should respond. Key points include:

What is Insolvency?: Insolvency occurs when a company is unable to pay its debts when they fall due (cash-flow test) and/or when its liabilities exceed its assets (balance-sheet test). For PFI project companies, insolvency is likely to occur when their financial models demonstrate that one or both of these tests are met.

Responsibilities of Directors: When a company is financially distressed, directors' duties shift from promoting the success of the company for its shareholders to protecting the interests of creditors. Directors must take appropriate legal and financial advice and keep a regular audit trail of decisions made.

Role of Insolvency Practitioners: Licensed insolvency practitioners are appointed to conduct the insolvency process. Their primary duty is to look after the interests of creditors, typically the lenders. They do not owe a duty to the contracting authority, shareholders, or subcontractors, except as potential creditors.

Types of Insolvency Proceedings: There are several types of insolvency proceedings, including:

• Administration: Aims to rescue the company as a going concern or achieve a better result for creditors.
• Receivership: Appointed over specific assets under a charge.
• Compulsory Liquidation: Forced closure and sale of assets to pay off debts, initiated by a winding-up petition.

Impact of Project Company Insolvency: Insolvency proceedings materially change contract relations and can disrupt service delivery. The insolvency practitioner takes control of the project company, and their primary duty is to creditors. This can result in service providers being unpaid and potential service disruptions.

Who Gets Paid on Insolvency?: Secured creditors are paid first, followed by preferential creditors (e.g., employees owed wages), and then unsecured creditors (e.g., subcontractors). Shareholders are paid last, if at all.

Insolvency and Events of Default: PFI contracts typically include events of default related to the commencement of insolvency proceedings. Loan agreements contain more sensitive tests of solvency and provide lenders with remedies such as terminating lending facilities and freezing project bank accounts.

Part 4 of the guidance document addresses the complexities of contract termination and the role of direct agreements in ensuring service continuity. Key points include:

Types of Termination: PFI contracts typically include several types of early termination:

• Voluntary Termination: Initiated by the contracting authority, not linked to events of default.
• Authority Default: Occurs due to non-payment or other limited obligations by the contracting authority.
• Contractor Default: Triggered by events of default caused by the project company, including insolvency.
• Force Majeure: Due to events beyond the control of the parties.

Consequences of Termination: Termination can have serious financial and budgetary consequences for contracting authorities, including:

• Termination Payments: Compensation payments vary depending on the type of termination. Contractor default termination typically results in lower compensation compared to voluntary termination.
• Service and Asset Risk: Early termination transfers the risk of service delivery and asset maintenance back to the contracting authority.
• Disputes and Litigation: Termination can lead to prolonged and costly legal disputes, especially over the grounds for termination and compensation amounts.
• Budget Implications: Early termination can have significant budgeting, accounting, and fiscal implications for contracting authorities.

Direct Agreements: Direct agreements establish the rights and priorities of the contracting authority and lenders in relation to the project company and its key subcontractors. These agreements are crucial in situations of project distress and termination. Key aspects include:

• Lender Direct Agreement: Provides lenders with step-in rights and confirms their priority over subcontractor agreements