Bankability Issues in Construction Contracts

Project Management Conference Yellowknife, N.W.T. November 23-24, 2015 ©Helmut K. Johannsen, P.Eng., C.Arb. Partner, Fasken Martineau DuMoulin LLP

Introduction

• Brief overview of basic Project Delivery Models as background

to discussion • Some basic bankability issues • Discussion of issues that impact bankability and/or financial

security requirements in contracts

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Introduction (cont’d)

• Bankability is often dependent on:

• Project Delivery Model • Contract Model • Pricing Model

• Are these all the same? • If not, what’s the difference?

• What are the Lender’s concerns • How do they affect the Contractor

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Project Delivery/Contract Model

• Project Delivery System (PDS): • PDS is a logistical decision by the Owner as to how project

risks will be managed and how different parties required for the project will participate in the project.

• PDS is an organizational structure adopted by Owners for the management of the design and construction of a project (Masterman, 2002)

or • PDS is the particular contractual arrangements for the

approach implemented or utilized by the Owner to accomplish a project´s goals, including organization, risk allocation, and the assigning of responsibilities, pricing and payment obligations (Juliana, Ramirez and Larkin, 2005)

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Project Delivery/Contract Model (cont’d)

• Contract Model • Follows the PDS adopted by the Owner • A generally understood form of contract that specifies the

risk allocation that is generally assumed to apply and govern the relationship between the parties, such as CCDC standard contract forms.

• May include one or more pricing models, which in turn may change the risk allocation generally assumed to apply by the contract model • e.g. Using CCDC 2 stipulated sum contract, but including

numerous cost reimbursable and unit prices for a majority of the scope of work

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Project Delivery/Contract Model (cont’d)

• PDS may include one or more of the following contract models: • Management (which includes those contracts in which the

Manager takes the risk of the delivery of the project and excludes all contracts in which the Manager is a consultant or good-effort contractor)

• “Traditional” (Design Bid Build) • Design-Build or EPC (which includes all contracts in which

the Contractor is responsible to the Owner for design) • Integrated-Collaborative (which includes all contracts based

on joint decisions, alliance agreements, BIM, IPD, etc.).

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Contract Models

• PDS may include one or more types of contract models

• Contracts for managing projects • PM (Project Management) • CM or ACM (Agency Construction Management –

Consulting) • CMAR or CM/GC or CM At-Risk (Construction Manager At

Risk)

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Contract Models (cont’d)

• Contracts for delivery of projects • Traditional (mixed responsibility)

• D-B-B (Design-Bid-Build or “Traditional”)

• Single Point Responsibility • D-B (Design-Build) • D-C or D&C (Design & Construct) • EPC (Engineer-Procure-Construct) • EPCI (Engineer-Procure-Construct-Install) • S&I (Supply & Install, or Design, Supply & Install) • EP+C (Engineer-Procure & Construct)

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Contract Models (cont’d)

• “Hybrid” type contracts • EPCM (Engineer-Procure-Construct-Manage) • EP+CM (Engineer-Procure & Construction Management)

• Concession Type Models • BBO (Buy-Build-Operate) • BOT (Build-Operate-Transfer) • BOO (Build-Own-Operate) • BOOT (Build-Own-Operate-Transfer) • DBFO (Design-Build-Finance-Operate) • FDBOM (Finance-Design-Build-Operate-Maintain) • “P3”, “PPP” (Public-Private Partnership) • BLT (Build-Lease-Transfer)

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Contract Models (cont’d)

• Non-Traditional Project Delivery Models • IPD (Integrated Project Delivery) • IPD (Innovative Project Delivery) • Alliance Contract

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Acronym Alley (cont’d)

• Contract models in turn may include one or more pricing models, such as: • FP (Fixed Price) • GMP (Guaranteed Maximum Price) • GMUP (Guaranteed Maximum Upset Price) • UP (Unit Price) • TP (Target Price) • Cost+ (Cost Plus) • Combination (stipulated &/or unit &/or reimbursable prices) • OB (Open Book)

• Depending on project, Lenders will look at the Project Delivery System, Contracting Model(s) and Pricing Model(s)

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Risk Transfer Increases Bankability Shifting the risk

Contract/Pricing Model Risk Owner Contractor

Management Contracts

Traditional Unit Price Bill of Approximate Quantity

Traditional Lump Sum Fixed Price / GMP

Design and Build Complete “Package”

Design, Build, Operate & Maintain

Construction Management

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Typical Design–Bid–Build Relationship

OWNER

CONTRACTOR

DESIGN CONSULTANTS CONSTRUCTION TO

OWNER’S DESIGN

PREPARE DESIGN

ADMINISTER CONTRACT

LENDER

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Design-Build/EPC Relationship (Theory)

OWNER

EPC CONTRACTOR

SPECIALTY SUBCONTRACTORS VENDORS LABOUR

EMPLOYER’S CONSULTANT

PERFORMANCE SPECIFICATIONS

ADMINISTER CONTRACT(?)

DESIGN TO PERFORMANCE SPECIFICATIONS, PROCURE AND CONSTRUCT

Note: EPC Contractor assumed to be a single integrated firm

LENDER

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Design-Build/EPC Relationship (Reality)

EMPLOYER

EPC CONTRACTOR

SUBCONTRACTORS VENDORS DESIGN CONSULTANTS

EMPLOYER’S CONSULTANT

DESIGN TO EMPLOYER’S REQUIREMENTS AND CONSTRUCT

PERFORMANCE SPECIFICATIONS

OR

OWNER’S REQUIREMENTS

ADMINISTER CONTRACT(?)

LENDER

Note: EPC Contractor on larger projects may be a joint venture, consortium, special-purpose vehicle, etc.

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Typical EPCM Relationship

EMPLOYER

CONSTRUCTION CONTRACTORS

VENDORS DESIGN / SERVICE PROVIDERS

EPC CONTRACTORS

EPCM CONTRACTOR

LENDER

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Construction Management (CM not “at risk”)

OWNER

Supplier

OWNER'S CONSULTANT

Trade Contractor Trade Contractor D/B Contractor

CONSTRUCTION MANAGER

LENDER

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Construction Management (CM “at risk”)

OWNER

Supplier

OWNER'S CONSULTANT

Trade Contractor Trade Contractor D/B Contractor

CONSTRUCTION MANAGER

LENDER

CONTRACTOR

CONSTRUCTION MANAGER TRANSITIONS TO BECOME

CONTRACTOR

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Basic Bankability Issues

• Approach of lenders to risk? • Project risk profile? • Relevance of:

• Project Delivery System • Contract Model • Pricing Model

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Lender’s “Wish List” for Financing

• Single point responsibility (i.e. EPC) • Reputable, creditworthy contractor(s) • Fixed completion date • Fixed contract price (subject to [limited] change orders) • Payment tied to completion of milestones • Minimum performance (“threshold”) guarantees for which

contractor has unlimited liability (i.e. contractor must keep working to achieve at least the threshold value of “x”)

• LDs for delay and non-performance above minimum (threshold) performance guarantees

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Lender’s “Wish List” for Financing (cont’d)

• Proven technology • Adequate performance security • Reasonable limitations on Contractor’s right to changes and

extensions of time; prior (discretionary) lender approval for material changes

• Contractor obligation for all permits, licences and approvals (in contractor’s name [and perhaps also in employer’s name])

• Reasonable defects liability period • Restriction on subcontracting except to reputable

subcontractors

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Pushback - Contractor’s “Wish List”

• Fair allocation of risk • Contractual right to variation/change orders adjusting

schedule and contract price • Non-interference by Owner • Assurance of payment from Owner • LDs that limit liability, rather than pay full loss suffered by

Owner for delay, non-performance, etc. • Caps on LDs • Overall cap on liability • Prompt resolution of disputes during course of project, not

deferred until after completion • Positive cash flow

• Question: How are these reconciled with Lender’s wish

list?

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Bankability/Role of Lenders

• Depending on type and value of contract, Lender protection provisions will be required

• Lender requirements will differ depending on amount of equity injected and type of financing used for project: • Financing project out of corporate debt • Project financing with recourse • Project financing without recourse

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Bankability/Role of Lenders (cont’d)

• Risk must be acceptable to Lenders or financing may not be available

• Risk analyses/assessments by Lenders may differ substantially from that of government party/private sector party • Parties may apply probabilistic approach to risks (especially

for cumulative risks) • Lenders may not use same probabilistic approach and/or

may look to “worst case scenarios”

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Bankability/Role of Lenders (cont’d)

• RISK REGISTERS • What are they? • Are they used/useful? • Only for Lender? Employer? Contractor? • When should they be prepared?

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Project Roadmap for Lenders

• In assessing risk, important that Lenders and Lender’s all understand the Project Delivery System, Contract Models and Pricing Models for the project

• Where project developed over several years often Owners documents contain numerous conflicts in design, cost estimates, schedule, etc.

• Consider developing a “Project Roadmap” • Facilitates Lender review • Facilitates obtaining internal Owner approvals • Identifies conflicts within documents as well as missing

information that could influence not only bankability but also lending rate

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Project Roadmap for Lenders (cont’d)

Project A Project Overview

• Project Components • Overall Project Structure/ Organization Chart • Overall Project Schedule • Overall Cost Estimate

B Market for Sales/Revenue C Overall Project Economics

• Capital Cost • O&M Costs

o Annual Cost o Sustaining Capital o Capital Replacements

• Project Cash Flow o Revenue o Account structure o Debt service o Equity return o Tax burden o Contingency o Depreciation

• Financial Model • Overall Project Economic Performance Projections • Taxation Summary

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Project Roadmap for Lenders (cont’d)

D Ownership and Governance • Sponsors (and background) • Shareholder Agreements • Project Ownership Summary •

E Funding Strategy • Capital Structure • Equity • Financing • Credit Enhancement/Govt Guarantees • Refinancing Risks

F Income Streams • Competiveness of Market • Sales Agreements • Integration with other facilities • Delayed Start-up Insurance • Business Interruption Insurance

G Real Estate • Ownership/Rights of Use

o Summary of First Nations agreements regarding land use

• Statutory Rights-of-Way • Other

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Project Roadmap for Lenders (cont’d)

H Project Risk Management • Risk Matrix • Project Insurance Overview • Project Bonding/Performance Security Overview • Project Contingency/Reserve • Schedule Risk Management

I Project Execution • Technologies • Contracting Strategy

o EPC v EPCM o Design Review & E&O Insurance o Contracts under EPCM o Contracts outside EPCM

• Integration with existing assets • EPCM Contract Overview • Liquidity to withstand cost/schedule over-runs • Guarantees and Warranties • Force Majeure Risks • Risks re Ancillary Infrastructure to support Project • Labour

o Project Labour Agreement o Availability o Productivity o Escalation

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Project Roadmap for Lenders (cont’d)

J Overall Project Operation • Operator Experience • Operation Agreements • Operation Risks • O&M Costs

K Environmental and Regulatory • Public Consultations • First Nations Consultations and Agreements • Environmental Assessments and Approvals • Regulatory

o Legal Framework o Permitting o Regulatory Review o Regulatory Approvals

L Project Status M Summary and Conclusions

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Project Roadmap for Lenders (cont’d)

• Lender protection in construction contract • Default by the Owner does not give Contractor grounds for

termination until after Lender receives notice of default and any cure period for a default by Lender has expired without the default being remedied

• Upon default, Lender may enforce its security agreement and acquire the Owner’s rights and benefits under the construction agreement and may sell them to a third party

• Until Lender has taken over the Owner’s rights and benefits under the contract (i.e. the Lender has exercised its “step-in” rights), the Lender is not liable for the obligation of the Owner

• After ceasing possession or control of the Owner’s rights and benefits, or after transferring them to a third party, Lender ceases to be liable for the obligation of the Owner

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Mega Projects

• Many mega projects are too large for a single EPC contract or a single contractor

• Split EPC contracts: Lender, Owner, Contractors, Subcontractors and Vendors may have concerns • Addressing concerns

• Clear contracts • Clear scope definition/battery limits • Clarification of inter-dependencies for performance guarantees • JV/Consortium as Contractor:

• All for one and one for all? Or everyone for themselves? • Should Owner/Lender be concerned? • EPCM contract: is it a bankable alternative?

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Bankability vs “Best Value”

• Evolution of Procurement Models, bankability, and attitude of Lenders to different models: • EPC/BOT/P3 • EPCM • Alliance Agreements • Integrated Project Delivery

• Lenders not concerned with “Best Value” as with minimum risk to Lender • As risk of catastrophic failure shifts from Contractor to

Owner, will Lenders also shift away? • Attitude of Lenders may stifle innovation unless Owner can

demonstrate reduced risk to Lender rather than increased risk • e.g. on mega project, breaking project into separate packages

may prove less risky than large single EPC contractor

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Lenders’ Direct Agreement

• What are they? • When are they used? • Lender perspective:

• What protection does the Lender really get? • In complex EPC or P3 scenario, will lender ever exercise its

rights and, if so, what are the consequences? • Contractor perspective:

• What benefit, if any, does contractor get? • What are the consequences to contractor if lender exercises

its step in rights?

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Lenders’ Direct Agreement (cont’d)

• Some Issues in Practice: • Must Contractor agree to changes to underlying contract

required by the Lender? • Or are these really driven by Owner to obtain a more

advantageous contract? • Should Contractor consent to security given to Lender

without seeing the security documents?

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Lenders’ Direct Agreement (cont’d)

• Some Issues in Practice (cont’d): • Potential delay and cost consequences

• Giving up of set-off rights? • Notice and time given to lender prior to suspension for non-

payment – who pays during this period? • Consequences of requirement to provide statement of accounts

due within x days and waiver of claims for anything not included

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Owner/Lender Step-in Rights

• If EPC Contractor insolvent, are Owner and Lender able to easily exercise step-in rights? • Difference between awarding an EPC contract to an

integrated EPC contractor vs. an EPC contractor that subcontracts design?

• For major equipment contracts for specialized equipment (turbines, mine processing equipment, etc.), are contractual remedies and security retained realistic or merely wishful thinking?

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Security for Contractor’s Performance

• Performance Security: • Letter of Credit/Bank Guarantee • Surety Bond • Parent Company Guarantee

• On demand or conditional security? • To secure physical performance or LDs? • Advantages and disadvantages of each to Lender, Employer

and Contractor • Lender preference is often in favour of liquidity – on demand

payment instruments • But is a 10% L/C really better than a 50% surety

performance bond?

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Security for Contractor’s Performance (cont’d)

• Can cumulative security requirements of Owner or required by Lender impact Project viability? • Performance + Guarantees + Warranty + Defect security

and/or holdbacks • Is Contractor partially financing the project?

• Delayed release of security/retentions/holdbacks • Does contract specify clear obligation and timing? • “Burn in Payments”

• Lender requirement that retentions not be released until end of warranty period

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Decennial Liability

• What is it? • Concept of responsabilité décennale originated in French

Civil Code and desire to protect building owners who could not ordinarily be expected to possess the technical expertise required to identify defects in design or construction at project turnover, particularly latent defects • Concept now adopted in some common law countries and/or

states within countries • Strict liability for period of 10 years from turnover, protecting

owner against collapse of building and latent defects • Decennial liability insurance available (and mandatory in

France and some other jurisdictions)

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Decennial Liability

• Why of interest in NWT/Nunavut and elsewhere in Canada? • If foreign or domestic contractors involved in project who

often contract in jurisdictions where decennial liability exists, may be possible to expressly include decennial liability in contract. • Rationale: can’t be opposed to this liability out of principle

because they agree to it in other jurisdictions • If decennial liability imposed, bankability enhanced • If decennial liability imposed and insured, bankability

enhanced further

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Security for Payments to Contractor

• How can Contractor satisfy itself it will be paid? • Owner obligation to demonstrate ability to pay?

• Production of financing documents • Securing payment obligations through bank

guarantees/letters of credit or advance payments? • Ability to suspend until payment assured?

• Contractor’s right of set-off? • If Lender exercises step-in rights, can Contractor demand

Lender pay unpaid invoices before Contractor resumes work? • What is Lender ’s obligation for unpaid work? • For work performed after loan default and before Lender

decides whether to complete, sell or abandon project?

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“Back to Back” Obligations & Liabilities

• What are they? • Lender’s concerns • Can everything be “back to back”?

• If LDs for outages in powerplant, for example, exceed value of subcontract or equipment supply contract, who will be responsible for the gap? • How can the gap be covered?

• Contingencies? • Insurance? • Retained risk by Owner/Contractor if catastrophic failure exceeds

Contractor/Subcontractor/Vendor ability to pay

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“Back to Back” Obligations (cont’d)

• Any problem with simply incorporating obligations in main agreements by reference into subordinate agreements? • Indemnity obligations • Liability for LDs • Dispute Resolution Provisions

• Requirement for conforming incorporated clauses to subordinate agreements

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Insurance as Risk Transfer Mechanism

• Owner controlled insurance program or Contractor controlled insurance program? • Disclosure requirements?

• Who has the obligation? • Consequences and liability to other insureds for failure to meet

disclosure obligations • Financing documents:

• Lender’s insurance requirements? or interference? • Loss payee issues? • Obligations to report loss and damage, and cause of loss and

damage, to Lender? Admissions against interest?

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Insurance as Risk Transfer Mechanism (cont’d)

• Project-specific insurance policies • Fixed term (i.e. 60 months) or floating term (i.e. “until

substantial performance”)? • Ability to renew/extend if project delayed?

• Liability of party who has obligation to insure if insurer refuses to renew policy (e.g. because claims have already been made and insurer has concern more claims may be made in future)?

• Multi-phase projects with differing start-up, commissioning and testing schedules?

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Insurance as Risk Transfer Mechanism (cont’d)

• Project-specific professional errors & omissions insurance • Insurer’s consent required to add parties? • Who is to be “first named” insured and required to meet

obligations of first named insured in policy? • What happens if not identified in contracts and consultants

refuse? • Is it worthwhile for megaprojects where limits are often

inadequate? • Are there alternatives that provide better value for money?

• Decennial liability/policies?

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Can Bankability be Enhanced?

• Select Project Delivery System, Contract Model(s) and Pricing Model(s) that reduce risk to Owner and, thus, to Lender

• Obtain “Indicative Rating” in advance from rating agency, based on preliminary documentation

• Prepare “road map” to documentation • Prepare overview documents to explain missing documents,

reconcile conflicting documents, and explain evolving developments

• Prepare comprehensive risk register in advance

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©Helmut K. Johannsen, P.Eng., C.Arb. hjohannsen@fasken.com +1-604-631-4819 49