UK: Key Themes In Distressed Projects

Last Updated: 9 September 2019
Article by Maria Pereira, Alison Fagan and Owen Knight

An insight into the key issues and challenges facing global infrastructure projects, and a look at possible solutions and mitigations.

In brief

Over a year on from the insolvency and collapse of British multinational facilities management and construction services company, Carillion, following a similar scare around Interserve's financial stability, a number of stakeholders in infrastructure and public private partnership (PPP) structured projects are reassessing their position and seeking assurances that their supply chains will not be next. While the Carillion and Interserve examples have had the largest impact on UK-based and UK-managed projects, the principles and lessons learned extend across the globe.

Each key stakeholder and stage of a project brings its own set of risks to the profitability and viability of a project. We would consider distressed projects to be those in which – what can be very low – performance triggers (be that KPIs, cost estimates or timetables) are breached on a recurring basis. While the likelihood of each distress factor manifesting is largely unknown, we can say with some certainty that a project will go through at least one, if not more, distressing event during its lifecycle.

Start on a high (risk venture)

The financial close of a project sees months, often years, of planning, preparation and negotiation culminate in the realization of a significant investment from all stakeholders. This injection of positivity and drive is essential at a project's outset, when the design, construction and practical completion – normally considered the highest risk stages – begin. However, over-promising (particularly from a contractor's perspective, in terms of ambitious timelines and low costs) and poor execution can be some of the first pitfalls in infrastructure projects.

Commencement delays

Delays to the commencement of works can be caused by a wide variety of issues, including late access, delays in obtaining necessary consents, unforeseen issues uncovered by ground condition surveys or issues with facility drawdown, many of which (if not all) will ordinarily be at the risk of the private sector (whether project company or supply chain) and can result in significant additional costs. Complete avoidance of these events is difficult, but the effects can be mitigated by using experienced project managers to plan and implement a project timeline (with sufficient buffer to accommodate any necessary variations or unforeseen circumstances), engaging with professional consultants and advisors as early in the process as possible to enable a comprehensive due diligence exercise to be carried out, and working to achievable milestones which have been stress-tested at all levels of the project.

Design and program variation

In an environment where customers expect more for less, a contractor may feel that in order to win a prestigious or financially necessary project it must offer a platinum-plated service. However, devising a timetable which exceeds projected expectations at an ambitious price point to secure an appointment may to lead to variations to design, program, or both. The contractor is likely to have risk-priced an element of delay into their construction model, but significant overruns and amendments driven by the customer can go far beyond predicated tolerances. Ensuring that there is a robust change mechanic and clear processes in place to deal with these issues can help, but pre-emptive measures can be taken during the procurement process to stress-test submissions to ensure that they are deliverable. Given the current climate in the UK, contracting authorities are moving away from favoring low cost bids, with the UK government's Outsourcing Playbook (the Playbook) introducing a concept of a low cost threshold in evaluation methodologies in an attempt to avoid awarding an unsustainable contract.

Defects

Defects in works, especially latent defects, can be discovered during or after the construction phase but, no matter when they come to light, can be extremely costly to rectify and have significant impact on project timelines and operation. A typical PPP contractual structure will see a construction contractor liable for defects for a defined period post-completion (e.g. 12 years), with a parent company standing behind this liability. To ensure that defects are caught within this limitation period, testing, surveys and completion milestones should be treated as important stand-alone stages of the project and not merely as a tick-box exercise. Uncovering defects early by conducting a thorough asset condition survey, for example in the UK at the nine-year mark (allowing time to rectify any issues before the 12-year limitation period expires), can help to minimize disruption and cost implications, as well as protecting the project company, lenders and even the client's position.

With the contractor market becoming increasingly stretched and defects claims strongly resisted, particularly when significant time has elapsed from the original works and evidential burdens are harder to meet, we are starting to see independent certifier claims develop as a method of recourse for project companies. As a result, the importance of drafting the independent certifier obligations, appointment documentation and any certificate is becoming increasingly prevalent, whereas certification has historically been seen as a formality which simply determines the length of the concession.

Operating as usual

An entirely successful project could be described as a project that no one has heard of (certainly not lawyers), in that it complies with all of the practical and contractual requirements, meaning that it is simply operating as usual and raises no red flags. Unfortunately, this is sometimes not the case.

Supply-chain failure

The falling away of the construction contractor – by virtue of the expiry of its limitation period – is not the only supply chain failure that a project can face during the operating phase. As eluded to above, the historic behaviors of large corporations to low-ball supply contracts (whether that be for construction works or facilities management services) results in complex interdependency and cash-flow issues and can lead to strain on the supplier's balance sheet if just a small number of its projects are underperforming. Pushing this tension to breaking point is one of the factors that contributed to the high-profile insolvency of Carillion in January 2018.

The insolvency of any supplier, let alone one as wide reaching and integrated into the market as Carillion, can have a drastic and long-lasting impact on a project. Immediately, events of default are likely to have been triggered under all major project documents and step-in rights of funders or clients could have crystallized. However, the likely concern of most parties is continuity of service and whether the project will continue to operate as usual. In our experience, interim arrangements can be put in place with alternate suppliers relatively quickly to give some level of normality, but these will often come with a trade-off that results in the project company bearing employment, deductions and legacy issues risk; positions which can be difficult to reverse when negotiating any long-term solution.

While it is difficult for project stakeholders to influence the financial health of its supply chain, measures can be put in place to assist with identifying and, to the extent possible, preventing the onset of insolvency as well as pre-empting the consequences, should suppliers fail.

  • Ensure that key supply contracts include comprehensive information reporting mechanics and corresponding audit rights, which are enforced to ensure that financial, employee and technical information held by the project company is up to date and verifiable. In the UK market a concept of board declarations that no “Financial Distress Event” exists is starting to be introduced in new procurements; however, directors should be mindful of their statutory duties and insolvency regulations and seek professional guidance when financial viability is being questioned.
  • Detailed governance procedures should provide for senior representatives from all relevant stakeholders to meet periodically to monitor the project's performance.
  • Key assets or funds (e.g. lifecycle budgets), which are integral to the delivery of the works and/or services, should be owned by the project company or sufficiently secured/ring-fenced so they are accessible following an insolvency event or change of supplier.
  • Insolvency termination rights should be drafted to cover the broad range of insolvency procedures applicable internationally, as well as extending the scope to cover that of any guarantor. Ideally, these rights should be triggered before any formal insolvency process, but this is likely to be resisted by any supplier and may contribute to the insolvency event in question.
  • A business continuity plan, disaster recovery plan and a supplier exit plan should be in place for the duration of a project. These are, again, requirements which should be evaluated during any procurement process, as mentioned in the Playbook.
  • Sufficient levels of corporate governance should be in place throughout the supply chain to enable the project company, or any incoming supplier, to quickly ascertain the key employees, asset ownership rights and sub-contracting arrangements to enable a smooth transition where necessary.

Performance issues

Disruption in a project's supply chain (as mentioned above) is likely to dramatically impact key performance indicators; however, smaller disruptions (such as a delay in self-reporting or a supplier not conducting statutory tests) can have just as big an impact on payment flows, depending on how the payment mechanism is structured.

Typically, these deductions will be flowed-down the supply chain to ensure that the party responsible for the performance failure bears the financial risk, although issues can arise when the cause of, or responsibility for, the deductions is disputed between the supply chain (particularly where legacy issues have been inherited from a previous supplier). The project company can be faced with the risk of cash-flowing these deductions or having to deal with a demotivated and combative supply chain, which will only compound the performance failure. Depending on the quantum involved, serious failures or supplier mismanagement may lead to an insolvency situation.

In addition to financial consequences, persistent service failure will begin to trigger warning notice thresholds and defaults under the project documents and, if left unremedied, may result in step-in or termination rights being exercised. We have seen difficulties arise in projects where there is a disconnect between the notice requirements and cure regimes in the project documents and the finance documents. This can result in tension between a project's lenders and the client, as a project company may be subject to a technical default under the finance documents before it has had an opportunity to remedy the issue upstream with its customer or allow for the appropriate cure period under the supply contract. We are seeing increasing levels of deductions and performance-related settlements between project parties in attempts to reset the balance and strive for the operating as usual equilibrium.

Concluding remarks

Since PPP/PFI became a preferred structure for infrastructure projects in the 1990s, many projects which adopted this approach are now coming towards the end of their contract life. This has led to a change in the nature of the issues encountered, with harsh consequences being felt. Lessons learned can be applied to newly procured projects to help develop a more robust approach to managing infrastructure projects from inception to handback.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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