In this article, we consider five issues which authorities should have in mind when looking to terminate a PFI contract. 

Terminating PFI contracts has never been more on trend as public bodies look at all options available to them to cut their outgoings; probably the most high profile termination came earlier this year when it was decided that the huge £3.8bn Greater Manchester Waste project is to be ended prematurely.

Why terminate?

The first question for any would-be terminating authority to consider is: why terminate? There is often a range of reasons. Amongst the most common are that the service standards do not meet expectations, relationships with the project company/FM company have broken down, the cost of the contract has escalated (whilst budgets have reduced), and there is a perceived lack of flexibility stymieing the authority's efforts to adapt their assets. In those circumstances, termination can seem an appealing prospect.

In fact, a large number of authorities are in similar positions with their PFI contracts yet very few have been terminated. That's because terminating a PFI contract is far from straightforward, as we will see.

The right to terminate

Once a clear, compelling rationale for terminating the PFI has been established, an authority must then consider whether it has the legal right to terminate the contract. Many PFI contracts do not include a right for an authority to unilaterally bring the contract to an end (a "voluntary termination" option). In which case, an authority may seek to terminate for contractor default – although this is notoriously difficult and should be reserved for only the most serious cases – or negotiate an exit with the project company.

The latter option can be difficult too, because project companies will drive a hard bargain knowing the strength of their position. Also, bear in mind that project companies are often owned by investment funds which prefer to have a reliable, long term source of income rather than a quick cash injection. Absent agreement of the project company, or a unilateral right to terminate, authorities are usually left with little option but to stay the course.

Cost of termination

Even where a right to terminate exists, the cost of termination is often prohibitively high. Unless terminating for default, an authority will usually be required to repay the outstanding debt plus breakage costs, the outstanding value of the equity, costs of redundancies and sub-contractor termination costs. There may also be a tax gross-up to pay in order to keep the project company whole.

These calculations can be complex. In particular, valuing the equity is often a significant source of contention. Not all project agreements are clear about the basis for such valuation, which can lead to a debate as to whether it should be based on, for example, the modelled value of the equity at contract signature or the actual value at the date of termination. In practice, the difference between such valuations can be tens of millions of pounds where project companies' profits have exceeded expectations.

Once the estimated termination cost is calculated, the authority will need to find the source of funds. This might require borrowing from (for instance) the Public Works Loan Board, the sponsoring government department or a local pension fund. It is rare that an authority would have sufficient cash to pay the termination costs outright.

How will the services be provided post-termination?

Authorities considering termination should have a clear, costed plan for the provision of services post-termination. Typically, staff employed by the FM contractor at the asset would transfer back to the authority under TUPE - unless a further procurement is carried out - so there should be a budgeted provision for paying those staff. Where the project is funded by PFI credits from a central government department, authorities should try to reach agreement that similar payments are made in lieu of those funds should the PFI credits be withdrawn when the PFI terminates.

Sufficient time should be built in to carry out new procurement processes, which may be achieved by extending the services provided by existing FM contractors beyond the termination date.

Alternatives

It is clear that there are a number of reasons why a PFI contract cannot be terminated, even where there are sound reasons for doing so (or strong political support – see Stella Creasy MP's recent comments in The Guardian, for example). However, a lack of money is usually the ultimate obstacle - as is often the case when it comes to the best laid plans in public administration.

So, if an authority can't terminate its PFI, what else can it do to better its position? Actually, quite a lot. To name just a few options, authorities could explore:

• taking advantage of low interest rates by refinancing the project, which can lead to lower debt repayments for the project company, the savings from which can be shared with the authority;
• taking certain services out of the scope of the PFI (soft FM services are commonly targeted in this way);
• putting in place stronger performance monitoring and enforcement mechanisms to incentivise improved performance.

If you are considering terminating your PFI contract, please get in touch. We have advised authorities, project companies, contractors and lenders on some of the most high profile terminations in the market and so are well placed to guide you through the process.