Keeping the lights on during and after corporate distress is never easy. The recent demise of Carillion Plc in the UK highlights how important it is for Government to have protections in contracts for provision of essential services. It also highlights the need for a clear strategy for Government principals in the unlikely event that corporate distress affects their service providers.
What happened?
Carillion Plc and its subsidiaries are parties to a large number of contracts with the UK Government, as well as Government clients in Canada and the Middle East. Carillion provides essential services to hospitals, schools, prisons and defence facilities. It is also involved in various large scale construction projects. In July 2017, the company announced significant write-downs on the value of its contracts. The group issued further profit warnings in the second half of 2017 and had a recapitalisation planned for 2018. At the start of January it appears Carillion attempted, without success, to broker a rescue package with plans to enter voluntary administration.
We expect Carillion's attempt to enter administration triggered default provisions in its various contracts. Given Carillion's key role in providing essential services, the UK Government discussed the possibility of a tax-payer funded bailout but decided not to proceed. It would appear the UK Government also decided not to exercise any rights it may have had to either step in or terminate under its direct service arrangements with Carillion. Notwithstanding the UK Government's short term actions, the very nature of liquidation means either a more permanent solution to Carillion's woes will need to be found (and relatively quickly) or Carillion will be wound up and/or its component companies sold.
What about the PPPs?
Carillion's write-downs reportedly included three public private partnership (PPP) projects. In a PPP, Government places its bets on the ability of, and incentive for, equity investors and lenders to intervene in order to keep the project running. No doubt, there will have been some urgent and uncomfortable conversations between the UK Government and the relevant debt and equity financiers about what should happen next. No doubt also, the UK Government will have looked to ensure that the project SPV companies shared some financial pain, but Government probably took the view there was little to be gained from a default termination of the PPPs themselves.
Rights to step in or terminate are all very well as a protection against project level SPV failure, but the collapse of a provider such as Carillion puts Government and PPP investors in more or less the same boat with the same limited options. In the short term, everyone has an interest in allowing the service provider to continue its activities, at least to the extent necessary to ensure continuity of service and continuity of associated service payments. In the meantime, other longer term options can be explored by all.
Lessons for Government contracting
Lesson 1: Negotiate appropriate contractual rights
Neither Government nor a service provider likes contemplating what should happen if the service provider (or a key subcontractor) is unable to provide services due to financial distress or insolvency. However, it is important for everyone that contractual arrangements provide appropriate options to anticipate and deal with these circumstances should they arise. This can include periodic verification of contractor solvency and considering whether (and how much) performance security should be provided. It may also include the ability to require new or increased performance security in the event of actual or pending financial distress. None of these options should be lightly negotiated away.
Lesson 2: Contractual rights facilitate other alternatives
Step in rights and rights to terminate are commonly considered Government's primary recourse if an essential services provider cannot in fact provide those services. Yet, it may not always be practicable, desirable or appropriate for Government to step in or terminate. In some cases, Government may choose to exercise those rights. In many others, they will not be exercised. Instead, it is the prospect of those rights being exercised that guides the negotiation path to a sensible, practicable alternative outcome.
Lesson 3: Think about security offensively and defensively
The existence of a security interest in Government's favour can provide Government with additional options in the event of financial distress. Depending on the project and the circumstances, there may be scope for Government to require a security interest, allowing it to rank ahead of ordinary creditors. A security interest can also allow Government to appoint a receiver, thus providing another option for the relevant project or services to continue while protecting Government's interests. The scale of the relevant project or undertaking, commerciality and market practice may all mitigate against this option, but it should be, at the least, considered when preparing and negotiating the relevant contracts.
Lesson 4: Government is not isolated from the risk by a PPP
While no bailout package was agreed between the UK Government and Carillion, the UK Government is now providing funds to Carillion's liquidator to ensure service continuity as well as ongoing employment (at this point in time) to Carillion's 20,000 plus UK workforce. If not a bail out, this is certainly a life raft.
Default termination of a PPP is by no means a cost free option for Government. If a key subcontractor becomes insolvent, there is an alignment of interests between Government and the project SPV to ensure survival of the PPP and continuity of performance. Equity investors may have some scope to contribute to the cost of this and Government should expect equity to step up. However, realistically, equity has limited scope (or agility) to refinance in order to provide a unilateral financial lifeline to its FM subcontractor. Even if this were not the case, only Government has the scale to respond to such a business-wide failure.
Lesson 5: Market concentration risk is a real concern
Governments enter into contracts one at a time. Eventually, many contracts add up to an exposure that is exaggerated by both scale and concentration on a portfolio view. This may justify additional preconditions at the procurement stage or additional protections for Government within its contracts.
Put simply, there are issues and risks that arise from having all of one's eggs in the same basket. Particularly in a smaller market (such as Australia), Carillion's collapse highlights the reason it is so important for Government to try and foster a sufficiently wide and well-equipped market of service providers.
