With this installment, we turn to a transcript that was first published in the Project Finance NewsWire in June 20015 and features Paul Weber, partner in our project finance group.
The topic today is construction contracts and the role they play in project finance transactions. One of the fundamental axioms of project finance is to make a catalog of risks and allocate each risk to the party best able to manage that risk. In the case of construction risk — which is a very significant one because projects typically involve complicated feats of engineering — what better person to allocate those risks to than the construction contractor who is well-schooled in managing those risks.
Let me start with the key objectives in negotiating an engineering construction and procurement contract in a project finance transaction.
The key objectives are to get the project built, first, in a manner that meets owner’s specifications and second, on time. The first objective is important because an owner should receive what it is paying for. The second objective is important because literally time is money. The longer it takes to build a project, the more interest one must pay during construction and the longer the wait until the project is in commercial operation and making money. For example, you may be building a power plant that will supply power under a power purchase agreement. The power purchase agreement may have a sunset date by which if the project is not in commercial operation, it loses the contract. Or the contract may have penalties for late commencement of operation because the utility has put the project into its integrated plan for supplying electricity to its customers. If the project is not in commercial operation when expected, that may cause problems for the utility.
Another objective is to get the project built at a fixed price. This is the case because another key axiom of project finance is that such financings are done on a non- or limited recourse basis. There is a defined pool of money — equity contributions, senior debt, perhaps also sub-debt, depending on the transaction. There is a budget and, if one exceeds that budget, there is only that defined pool to call on before the project runs out of money and runs into problems. And, of course, the higher the owner’s capital costs, the lower its return.
A good construction contract puts as much responsibility for meeting these objectives as possible on the contractor.
Contractor’s viewThe contractor is in the project to make money just like everyone else. When a contractor bids the job, he prices the many aspects of the work. A lot of the work will be done through subcontractors and vendors. The contractor wants to have back-to-back contracts with those subcontractors so that it can lay off as much risk as possible on the subcontractors. That being said, the typical construction contract in a project finance transaction is a “turn-key” contract. That means that the contractor is the person with the responsibility to get the project built so that, if a subcontractor fails to perform from the owner’s perspective, it is the contractor’s responsibility. In fact, in every construction contract, the project is implicitly paying for this “turn-key wrap” and the premium paid for this is substantial.
The contractor also wants to avoid taking risks outside of its control or contemplation. Thus, a contractor wants to have as well-defined a scope of work as possible, and it does not want to be responsible for things that it cannot control or foresee. Contractors report that a typical construction contract does not have a large profit margin. Whether or not you believe this cry of poverty, a contractor will try jealously to protect that profit margin and limit its downside.
Lender’ viewThe lender’s interests are largely aligned with the owner’s interests.
A lender wants comfort that the project will work, be done on time at a fixed price and perform as promised. A lender will undertake due diligence of the contract on at least four levels. One is the technical review done by an independent engineer. The independent engineer assesses the contract, looks at the technical specifications, liaises with the contractor, makes a determination as to whether the project will hang together, and puts its conclusions in an independent engineer’s report that is delivered to the lender as a condition to closing. The second piece of that review is legal review. A lawyer will review the contract, assess the risks and let the lender know whether it is a market contract — whether there are risks that are outside market norms. The third reviewer will be an insurance adviser, who will look at the insurance package. Infrastructure projects are complicated enterprises. They involve heavy equipment. Things can go wrong, and insurance is important. Finally, the lender does a business review, looking at the economics of the contract. Lenders also protect their interests by engaging the independent engineer to monitor construction progress of the contractor throughout the performance of the contract.
Contractor’s responsibilitiesI have outlined the key objectives in a construction contract. The following discussion about the contractor’s responsibilities is framed in terms of those key objectives with a few necessary digressions along the way.
One of the ways that the owner makes sure that it will get what it expects is through a very extensive scope of work in the contract. Just to provide a crude sense of how critical a broad scope is, it is not unusual for the “contractor responsibilities” section of the contract to run some 20 pages long. The contractor will be responsible for all the engineering and design work. It will be responsible for construction and construction management. Construction management is managing all the subcontractors and the like and making sure everyone is doing his or her part in a well-coordinated way. The contractor will be responsible for procurement of all equipment and materials and, to the extent that it is not itself an equipment provider, like General Electric or Siemens Westinghouse, it will subcontract with vendors to provide that equipment. It will provide all construction labor and personnel.
The contractor will also be responsible for permitting, although a contractor will only typically be responsible for permits that are customarily obtained in the name of the contractor. There will be many permits that, by their nature, must be obtained by the owner.
The contractor will be responsible for the start up and initial operation of the facility. That is when the project is first turned on and then ramped up to rid the project of kinks. Testing, which is a vital piece of any construction contract, will be a contractor responsibility. Usually, the contractor must also provide training of the owner’s or operator’s personnel. There will also be reporting requirements — typically a monthly progress report setting forth progress the contractor has made toward meeting milestones, any problems it has encountered, and any expectations of changes in the scope. The other way in which the contract defines the contractor’s scope is through what is typically exhibit A or 1 to any construction contract, and that is the technical scope exhibit. This is a key document and is generally the domain of the engineers.
SubcontractsVirtually every construction contract will have a section on subcontractors and vendors because the typical contractor may do a lot of the design and engineering work in house, but may not have a huge staff of construction labor standing by that can work on a project. The prime contractor must go out and hire that labor. It may not make turbines, so it buys those turbines from a GE. The point is subcontracts are a key piece of the deal. They are somewhat opaque to the lawyer negotiating the prime contract because of the turn-key nature of the agreement. The subcontract section will say that the use of subcontractors by the contractor has no legal effect on the contractor’s responsibility for the work. In other words, if a contractor or vendor does not perform, generally that is not an excuse for non-performance by the main contractor. It will also say that the owner has no privity with — or direct legal rights against — the subcontractors.
Nonetheless, the choice of subcontractors can be critical to a deal. For example, in a power project, the owner will be very interested in what sort of turbines are being purchased by the contractor. There are numerous other items of equipment in which the owner will also have a keen interest. The owner may have had a bad experience with a particular vendor and does not want to use that vendor again. The owner needs some control over the choice of subcontractors.
The typical means for addressing this in a construction contract is through use of an approved list — an exhibit that says for this type of equipment, contractor can use these companies and no others. There may also be a provision in the contract that says any subcontract involving more than a specified dollar amount of work must be approved by the owner. Sometimes the contract may use both a list and an approval threshold.
My final remark about subcontracts is that even though the prime contract has the turn-key wrap, the owner is aware that the contractor is looking through to the subcontracts to perform many of its obligations. Thus, for example, even though the contractor provides a warranty for the entire facility, the owner wants to know that if a turbine the contractor bought does not work, then the contractor can turn to the turbine manufacturer and say, I have a warranty claim under my main contract so I need you to perform under your warranty to me. This means the owner wants the warranties under the major subcontracts to be at least coextensive with the contractor’s warranty. The owner will want to know that the insurance provisions under the subcontracts are comparable to those under the main contract. The owner will want to know that the subcontract can be assigned to the owner under certain circumstances.
Owner’s responsibilitiesA much shorter provision of the construction contract (relative to the contractor’s scope) is the section on owner’s obligations. That should not be surprising.
The owner’s principal obligation is to pay money for performance.
The owner will have other obligations that will include providing the site and necessary access rights to the site. The contract may also require provision of something called a construction lay down area, where the contractor puts its materials while it is building the facility. The contract will require the owner to appoint a representative to act as a single point of contact for the contractor to deal with on any issues that come up under the contract. It helps both sides to know that there is one person to turn to if decisions need to be made or approvals obtained. A third obligation is to obtain owner permits. Owner permits will often be critical items for the project. For example, the owner will probably need an air permit before the contractor can even put a shovel in the ground. he owner must provide the personnel needed to start up the facility. The contractor is responsible for training them.
There will be other deal-specific obligations. For example, the owner might be responsible for assuring in a power plant deal that the interconnection to the utility is built on time.
Three key conceptsThere are three events, among numerous important events, in the process of construction that are critical. These events are defined in most, if not all, construction contracts using various terms. The reason these are important is they are used to capture the notion that the project is being built to owner specifications and working as promised. They are also used to define timely completion.
The first key event is mechanical completion. Mechanical completion means that the facility is physically complete, except for a few punchlist items. The plant can be turned on safely and is ready for performance testing.
Substantial completion is perhaps the most important of these three concepts. It occurs when mechanical completion has occurred, the facility is ready to be put into commercial operation, the performance tests have been completed and the performance guarantees have been satisfied. I will describe shortly what I mean by satisfied.
The final concept is final completion — that substantial completion has occurred, the punchlist has been completed and all other work has been completed. There might be a requirement that the contractor deliver something called as-built drawings. There might also be other minor items that must be done in order to achieve final completion.
The next topic is performance guarantees and the tests performed to determine whether substantial completion has occurred.
These tests can vary from deal to deal. I will use the example of a power plant, but it is not hard, once you understand the conceptual framework, to see how such tests and guarantees would apply to numerous other types of facilities.
The first test is an output test. In this test, you are testing whether the facility can produce at the promised levels. If the owner has contracted for a 100-megawatt power plant, it wants the contractor to demonstrate that, in fact, when it turns the facility on and runs it at specified conditions, the plant will produce 100 megawatts. Obviously, this is key for several reasons. You may have a power purchase agreement that says you will deliver 100 megawatts. You have a financial model into which you have plugged the number 100 megawatts as the output, and you have multiplied that number by your expected sale price and come up with your expected cash flow.
The purpose of the output test is to meet the guaranteed output level or pay liquidated damages. Liquidated damages are typical in construction contracts and, when it comes to output, the owner will calculate the cost to it if the plant only produces, say, 98 megawatts. The calculation is not hard to do. You plug 98 megawatts of capacity and output into your financial model and you see the impact on cash flow, you do a net present value calculation and you come up with a number. For each megawatt or fraction thereof by which the guaranteed level is not met, the owner will want a liquidated damage payment from the contractor that will make it whole. In reality, do owners achieve this goal to the last dime? No, but that is the goal.
The lender perspective on this is that it lent the owner $100 million to build a 100-megawatt plant, and the lender is expecting the plant to generate certain cash flows that will service its debt and generate debt service coverage ratios at certain levels. If the plant only produces 98 megawatts, those debt service coverage ratios will be negatively affected. The lender’s position is that it wants to preserve its deal, so the owner will be required to take the liquidated damages money it receives from the contractor and prepay a portion of the loan, thus reducing the amount of the debt so that the debt service coverage ratios are restored.
On the positive side, the contract might provide for a bonus to be paid for exceeding guaranteed levels. My experience is that if you offer a contractor a bonus for exceeding guaranteed levels, then the contractor will very often achieve those higher levels. Contractors are generally conservative; they want to know that they can meet the performance guarantees. If a contractor is promising a 100-megawatt plant, it does not design the plant for 100 megawatts; it designs the plant for, say, 106 megawatts. A bonus may be appropriate, but you must look at whether there will be an economic benefit to the owner. If the power purchase agreement commits to supply 100 megawatts to a utility and the owner has no place to sell any excess generation, then it does the owner no good if its plant produces five megawatts more than it bargained for. A bonus in that situation would not be appropriate. If, on the other hand, its contract provides that the utility will take and pay for excess production up to a certain level, then exceeding the guaranteed levels will be worth something to the owner and a bonus would be appropriate. The bonus might be calculated based on some sort of splitting of the benefit with the contractor.
The second test is an efficiency test, known in the context of a power deal as the heat rate test. The efficiency test determines how many inputs it takes to get the anticipated output. There will be a specified number. If the owner has to burn 5% more fuel than it anticipated burning in order to produce each megawatt of power, then that means, for the life of the deal, the owner will have fuel costs that exceed those by 5% in its pro forma model. That increased cost may go on forever. You can see how that efficiency shortfall goes straight to the bottom line. Thus, under the efficiency guarantee, the contractor guarantees that the project will produce X amount of output based on Y amount of input. If it fails in a performance test to demonstrate the ability to do so, liquidated damages will be payable. In determining the level of liquidated damages, the same sort of analysis for the output guarantee applies here. The owner will determine the effect on the economics of having to pay for an additional 5% of fuel for the life of the deal and look to get back to a position where it is economically whole. The lenders will do the same analysis I described for an output shortfall, although in this case it is not that there will be less revenue from the plant, but higher expenses. Once again, the debt service coverage ratios will be negatively affected. The lender will want to take the delay liquidated damages, use them to prepay debt and get back to the coverages it bargained for.
A bonus for higher efficiency generally makes sense; if the owner can produce its output for less money, then clearly there is a benefit in which the contractor may well want to share.
Satisfaction of the performance guarantees means either meeting them or paying liquidated damages and being deemed to have met them. That said, a typical construction contract will stipulate minimum performance levels that must be met before a contractor can satisfy the guarantee by paying liquidated damages. A contract may provide that the contractor must get to 95% at least on output and 105% on efficiency before it even has the right to pay liquidated damages to buy down its obligation on performance. Below this level, the contractor’s performance is so out of line from expectations that the performance is not acceptable and the contractor must do whatever it takes to get to the minimum levels.
Other guaranteesAnother typical performance guarantee in a construction contract is the emissions guarantee. The emissions guarantee is typically based on permissible emissions levels in the project’s air permit. The air permit will contain significant detail about what levels of emissions of things like NOx, SO2 and mercury are permissible. The emissions guarantee must be met at the guaranteed levels. No buy down is allowed. You do not want a plant that is 95% in compliance with emissions laws. This is not an economic test. It is an on-off test. If the plant exceeds allowable emissions levels, then it may not be able to operate at all. Passing the emissions test is essential.
That sums up performance guarantees and tests — a critical part of any construction contract and one that will attract a lot of attention, not just from the lawyers, but also from the independent engineer, who will make sure that the tests are good tests and that they are designed to measure what they are supposed to measure. The business people will also look at the numbers in the pro forma model to determine whether the liquidated damages are set at the proper levels.
Timely completionThe concept of getting the project built on time is principally captured through something called the guaranteed substantial completion date.
Achieving substantial completion means, among other things, that the facility works and is ready to go into commercial operation. That is when the deal goes from being all outgo to having some money coming in. You turn it on, you start producing whatever you are producing and start making money. The owner’s offtake contract may also have a sunset date or penalties for late performance. Therefore, the timeliness of achieving substantial completion is important. This timeliness is enforced by stipulating a guaranteed substantial completion date. The contractor will guarantee that the plant will be built and achieve substantial completion by a certain date. If the contractor does not achieve substantial completion by that date, then it must pay liquidated damages. These liquidated damages are somewhat different than the performance or efficiency damages in that they are addressing what is effectively a temporary problem. It is not something the owner must live with for the life of the deal as is the case with reduced output or lower efficiency. Rather, the owner expected to be in operation and making money by a certain date so that it can pay interest on its loans and start making an equity return. For every day the owner is not in operation, it expects the contractor to pay liquidated damages sized to make the owner whole. Will the owner be made entirely whole in terms of getting its full equity return? Probably not, but the owner wants to get close to this result while the lender just wants to know that money will be there to start paying its loan and keep the project going.
Early substantial completion may earn a bonus. There should be a benefit to the owner before a bonus is warranted. If the offtaker doesn’t want the owner to be in production until June 1, and has no obligation to take its output until then, then owner should not pay the contractor a bonus for getting it to substantial completion by April 1.
In some contracts, there may be a negotiation about reducing the amount of delay liquidated damages, payable to the extent owner is receiving revenue. Suppose a contractor is toiling away to get the plant done and cannot quite get there, but the plant is operating and owner is actually in operation and making money. The contractor will insist the liquidated damages it is paying should be reduced by the amount of the owner’s net revenues.
There are other means of assuring that the project is built in a timely fashion. Obviously, the owner does not want to wait until the guaranteed substantial completion date has come and gone if it is clear at an earlier time that performance is lagging. The owner wants the plant built on time and will closely monitor progress. Payments to the contractor will be tied to the achievement of milestones. The owner may have a right to say to the contractor that it has fallen seriously behind and the contractor must go to double shifts to catch up. That will cost the contractor money and the contractor will be unhappy, but a good owner and its lawyer will seek this right.
Liability limitationsThe contractor’s perspective is to lay off the risk and protect its profit margin. Thus, all construction contracts have liability limitations as they relate to liquidated damages.
Liquidated damages will be typically limited to a percentage of the contract price. In a power deal, the cap on liquidated damages will often be somewhere in the neighborhood of 25 to 30% of the contract price. It could be higher when you are dealing with a more risky technology. It will be higher, for example, in windpower projects. This is a money point, and the contractor may say that it can agree to a higher cap, but it has to pay its subcontractors extra for it and the contractor will pass through those costs to the owner. In addition, it is common for there to be sub-caps on liquidated damages. The contract might have a 25% overall liability cap on liquidated damages, but for output and efficiency it will be 15%, and for delay damages it will be 15%.
One analyzes the adequacy of these caps and the liquidated damages through a mathematical exercise based on certain assumptions. For example, the project may involve a turbine that has been used in a hundred other facilities and it always works. The worst that has ever happened is it comes in 2% short. If the contractor is 2% short on its output guarantee, that will use X% of the cap. Through this sort of thinking, you know whether the cap makes sense. Similarly, for a delay, the owner should determine what is a reasonable worst case number of days of delay.
The owner takes its delay damages for every day specified in the contract, and takes the cap and divides it by the daily amount. This results in a number of days of coverage for delay that the owner can compare against its reasonable worst-case expectations to determine whether the damages cap makes sense.
The contractor will also try to limit its overall liability under the construction contract for performing all of the work. This is not an absolute rule, but typically the overall liability cap will be 100% of the contract price. There are some exceptions to the 100% cap for things like third-party liability. For example, if the contractor’s turbine falls off a truck and kills people, then that will attract significant liability and that will be outside the cap and should be covered by insurance. The contractor may negotiate for the overall cap to step down at mechanical completion to a level below 100% of the contract price. At mechanical completion, everything has been delivered and put together so the owner knows that any problems that remain will probably be adequately covered by a reduced cap. If you have a $500 million contract, a step down to a 40% cap still leaves $200 million.
Payment provisionsTypically, installments are paid based on completion of milestones. There will be a milestone schedule that includes milestones like payment of $10 million at “start of construction” or “issuance of the notice to proceed,” payment of another $10 million upon “completion of engineering,” and payment of $20 million upon installation of X equipment. In some contracts, payments are made based on the percentage of work completed. From a lender’s perspective, the independent engineer will monitor this construction progress closely to verify the progress of the construction. Other payment conditions will include, for example, absence of a material breach and provision of lien waivers by the contractor.
The payment provisions will also provide for something called retainage. Retainage is an amount that the owner holds back from each payment — typically from 5 to 10% of each amount due to the contractor. Retainage is held back as a form of security for contractor’s performance. If, for example, the contractor fails to complete some portion of the work on deadline, the owner may be able to use the retainage money to pay someone else to do the work. The Owner may also set off retainage amounts against liquidated damages. This is a way of keeping the contractor interested, because he knows that he must get the owner to substantial completion to get most of the retainage money and then to final completion to get the rest of the retainage money. The contractor’s profit margin may not be large, so if the owner is withholding 10% of the contractor’s payments, that might be a pretty good chunk of its profit and a good way to keep the contractor focused. Contractors may, for cash management reasons, want to give the owner a letter of credit instead of actually having owner withhold cash.
Change ordersChange orders are the means by which the contractor protects itself and can come back to owner and say, these things have happened, I deserve a change in the contract price, maybe in the project schedule, including the guaranteed completion date, and maybe the performance guarantees. Some events that may affect the contractor’s performance and permit change orders are things like owner delay. The owner was supposed to have the interconnection done by a certain date so the contractor could hook the plant up to the grid and start performance testing. The owner could not do it. The contractor says it cannot perform because the owner has not performed, and so it should at least get schedule relief and push back the guaranteed substantial completion date.
Owner breach and force majeure may also justify a change order. Something happened — the plant is struck by lightning and partially destroyed. Typically what owner’s counsel wants to negotiate toward is schedule relief for the contractor. It gets a delay in schedule, but takes the risk on cost. Some of the cost risk can be laid off on subcontractors, and some can be insured. Change in law is another basis for a change order. The law changes, and contractor has to add $10 million in additional pollution control equipment. It is unfair to say that the contractor has to provide all that pollution control equipment without an adjustment to the deal. The contractor will say it wants a change order — a new price, a new schedule and a new guaranteed completion date. The contractor may encounter subsurface conditions that were unexpected. It might excavate the site and encounter valuable, historic artifacts that require it to stop working and call an archaeologist to dust them off and remove them before it can resume. It may run into environmental contamination. These sorts of events may lead to change orders.
The owner protects itself against change orders by having as broad a scope as possible so when the contractor comes back and says something is not in the scope, the owner can point to the scope provisions and disagree. The owner will also ask the contractor to make representations that it has done an assessment of the site conditions and, unless something falls outside of everyone’s expectations about the site, it cannot come back for a change order. The contractor may also be asked to make representations that it understands a broad range of conditions that could affect performance. For example, it might represent that it has done an assessment of weather conditions. If it is building in India, the contractor cannot come back to the owner and say it did not know about the monsoon season. That is how the owner protects itself.
WarrantiesThe owner has protected itself in terms of getting the project built, getting it built to specifications, and performance testing to make sure it works. Now the owner has to put it into operation, and these are typically complicated projects. Things go wrong. Things break. The owner needs warranty protection, and it will come in several forms. I will touch mainly on the simplest form of warranty, and that is a general warranty.
A general warranty will say that everything — machinery, equipment and materials, etc. — is free from defective workmanship and complies with the specifications in the contract and the scope document. It will typically provide for a warranty period of one year to 18 months from substantial completion. That is, the project has to break within that period and the owner has to tell the contractor about it; otherwise, the owner is on his own. The warranty period may vary, depending on the technology. For example, in windpower transactions, the technology is advancing so fast and there have been problems with the technology, so contractors and vendors have been pushed by the market to stand behind a wind turbine for up to five years and sometimes longer. The warranty provisions will also state that if there is warranty work — if something broke in the ninth month and contractor fixed it — that portion of the work will be re-warranted for an additional six-month period, but not beyond, say, 18 or 24 months after substantial completion. The contractor will warrant title; title is what the contractor delivers to the owner in exchange for payment of the contract price. The contractor will insist that the owner waive all other warranties, expressed or implied, including all UCC warranties.
Other issuesIndemnification provisions in construction contracts include a general indemnity against third party claims. Typically that is a mutual indemnity. Often there will be reciprocal environmental indemnities. The contractor will take the position that pre-existing conditions on the site are the owner’s responsibility. The owner will agree, but insist that if spills or any environmental problems are due to materials that the contractor brought to the site and actions the contractor took at the site, the contractor must indemnify the owner.
Finally, the contract will include a patent and copyright indemnity. The owner is often buying equipment that is subject to patent or copyright protection. The owner wants to make sure that it has the right to use the equipment. The contractor will give the owner an indemnity to that effect. If the indemnity is breached, then the contractor’s obligation will not generally be to pay the owner money, but instead will be to fix the problem by obtaining for the owner a license to use that patented or copyrighted equipment or work.
A construction contract will typically provide that the owner can terminate the contract or suspend the contract for its convenience. It can suspend performance, typically for a limited period of time. These provisions sometimes are useful if the owner runs into a problem with its lender, and the lender says it will not advance any more money until the problem is fixed. The owner does not want to be in a position where money is cut off by its lender, leading to loss of the construction contract. In this instance, owner may use its suspension provision. The exercise will cost the owner money, but will save the contract.
Finally, let’s talk about remedies for breach of a construction contract. One of the key remedies will be termination of the contract. After a termination, the owner can take over the subcontracts. That is why assignability of subcontracts is important. The owner can take over the existing designs and drawings, get those from the contractor, bring someone else in to complete the facility, and then charge back the difference in cost to the contractor. If the contract price was $100 million and the contractor breached, the owner terminated and hired another contractor at a total cost of $110 million, then the owner has a claim under the contract against the contractor for that $10 million. It is a damages claim. It can be set off against any security the owner holds, but it will probably end up being settled in court or in an arbitration. The owner will also want to preserve other legal and equitable remedies. A lot of contractors like to say the remedies in the agreement are the only remedies the owner has, but I always try to resist that because I prefer not to limit the universe of remedies that the owner has in the event something goes wrong.