How are liquidated damages (“LADs”) used in construction contracts forming part of project finance arrangements?
Project financed deals rely on the revenue stream created by the project. Every project is built upon a financial model which forecasts the length of time it will take the private sector special purpose vehicle (“SPV”) to repay the funder and generate a profit from the asset. Therefore, the success of the project is dictated by the ability of the SPV to follow its financial model. However, where a construction delay results in a gap in the financial model, LADs can assist the SPV in plugging this gap.
Why is the completion date so important?
On project financed deals, the SPV will typically be granted a concession from the Authority to design, build, finance and operate an asset for a period of 25 to 50 years from practical completion (“the concession period”), receiving income during that period either for services provided or from end users paying to use the asset.
Only in very limited circumstances would the SPV be granted an extension to the concession period. A delay to construction therefore has the potential to shorten the concession period and reduce the potential to generate income, leaving a hole for the SPV to fill.
The relationship with LADs
As the SPV is automatically incentivised to achieve the completion date, the project agreement between the Authority and the SPV will usually not contain LAD provisions.
However, the SPV and funder will require robust LAD provisions to be included in the construction contract to ensure the SPV is “kept whole” if the construction is delayed. The general premise on project financed deals is that the LADs compensate the SPV for having a reduced concession period during which to generate its income due to construction.
As the project agreement’s concession length will only be extended in limited circumstances, the extension of time entitlements under the construction contract will be back-to-back with the project agreement. Therefore, the events for which the construction contractor will be relieved from LADs under the construction contract are limited to, typically, only SPV breach or variations. Contrasted with an unamended JCT Design and Build 2016 (or most other standard form design & build contracts) where the contractor has a wide range of potential reliefs from LADs – including delays to construction caused by strike or bad weather – the delay risk on the contractor is much greater.
Therefore, contractors operating in the project finance sector will need to ensure it is properly insured against events which, under a straight "design & build", would typically entitle them to relief from LADs.
This article is part of a series which will look at the contractual terms that special purpose vehicles and funders will use to de-risk the construction period of a project and ensure that the project goes on to achieve its projected rate of return.
Written by Greg Fearn