Legal blog: Ways of escape - undoing PFI

With the Labour Party riding high in the polls after a tumultuous year in British politics, shadow chancellor John McDonnell used his speech at the party conference to pledge that a future Labour government would “bring existing PFI contracts back in-house”.

He cited the waste of taxpayer money – in contrast with the “enormous profits” for private companies – as grounds to “put an end to this scandal”. 

Setting aside the politics surrounding the pros and cons of PFI contracts, I have considered below how the government could go about bringing PFI contracts “in-house” and the potential costs that this could incur.

Labour issued a briefing note accompanying McDonnell’s speech, stating they would consult on “appropriate methods for returning the ownership and responsibilities of SPVs [special purpose vehicles] to the public sector, with shares-for-bonds nationalisation (via an act of parliament) the presumed preferred approach”.

The contractors that enter into PFI contracts with the public sector are generally SPVs with around 90% of their funding provided by banks and the remainder provided by the equity holders.  

Setting aside the likely difficulties of how such an act of parliament could fairly value the equity in such SPVs, the public sector would in any case, under this approach, become the owner of an SPV with a potentially large outstanding loan and an obligation to make substantial interest payments – not to mention that the banks would have security over all its assets and rights under the PFI contract.

If a government does adopt a policy of bringing back these PFI contracts, it will be good news for the lawyers, as they will inevitably be picked over. Now, where’s that magic money tree? 

Given that one of the main criticisms of PFI contracts is that they do not provide good value for money (as the public sector can borrow at cheaper rates than the private sector), such an approach would not appear at first glance to resolve the issue.

An alternative could be to terminate the contract, if the cost of financing such a termination and paying for the services to be delivered under the PFI contract was likely to be lower than continuing to the end of the PFI contract’s term.

Generally if you terminate a contract, unless as a result of default by the other party, then you will have to compensate that other party for profit lost as a result of the termination. However, most PFI contracts contain a voluntary right for the authority to terminate, with the consequences of such a termination expressly set out.

If a PFI contract contains no such right, it could only be brought to an end through establishing that the authority has a right to terminate due to a default by the PFI contractor, by the authority unilaterally abandoning the contract in breach of its terms, or by negotiating a termination by agreement.

The authority is likely to prefer to negotiate any such termination, irrespective of the reason for termination, to avoid the uncertainty and publicity of litigation. However, such a negotiation will always take place against the background of the parties’ contractual rights.

The consequences of termination depend on the terms of the relevant contract.  However, PFI contracts are generally in similar forms that follow relevant Treasury guidance.  This provides that for a voluntary termination, the PFI contractor should receive a termination payment which leaves it in the position in which it would have been had the contract run its full course.

This termination payment will generally include:

• The “base senior debt termination amount” –  generally defined as including all amounts outstanding to the funders (including accrued interest) and all other costs of pre-payment of the PFI contractor’s loan, such as the costs of terminating interest rate hedging arrangements 
• Redundancy payments for employees of the PFI contractor reasonably incurred as a direct result of the termination
• Subcontractor breakage costs – compensation payable to relevant contractors as a result of the termination of their contract
• Compensation for equity holders in the PFI contractor. How this is calculated will depend on the terms of the relevant PFI contract but will generally be based on: (i) a sum that, when added to sums previously paid to the equity holders, equals their projected rate of return in the financial model, or (ii) the open-market value of the equity, or (iii) all the sums due to be paid to the equity holders under the financial model from the termination date.

The costs of such a termination are likely to be substantial. Consideration would also have to be given to who would deliver the services being provided by the PFI contractor after termination and at what price.

Termination may therefore not offer the best value for money to the authority. It may consider other options, such as:

• Changing the scope of services to be delivered by the PFI contractor
• Taking a stronger line on the enforcement of its rights under the PFI contract.

As to the latter point, pressure on budgets may lead to a tendency to dispute the SPV’s entitlements under the PFI contract.

One thing is for certain – if a government does adopt a policy of bringing back these PFI contracts, it will be good news for the lawyers, as they will inevitably be picked over. Now, where’s that magic money tree?