- Risk Allocation in P3s
- October 15, 2015 | Author: Harry Z. Rippeon
- Law Firm: Smith, Currie & Hancock LLP - Atlanta Office
- The success or failure of many construction projects depends on accurate risk evaluation. How well a party can evaluate, shift, or price risk can be a determining factor in the project’s overall success and the party’s financial well-being. Under traditional project delivery methods, an owner provided the necessary site and design to the contractor for construction and took the keys upon project completion. Owners, both public and private, bore the risk of providing an accessible site, adequate design, necessary governmental approvals, and ultimate operation and maintenance. In the past decade, many owners have sought to move away from this traditional risk allocation. The popularity of the design-build method is in part a result of owners seeking to shift the risk of project design. Other project delivery methods such as CM at Risk and Integrated Project Delivery also change traditional project delivery risk allocation. For contractors, one of the most challenging new developments is the increased use of Public-Private Partnerships, commonly referred to as P3s or PPP’s. P3s have become a valuable tool for public owners to overcome the financing burdens for large education, transportation, or utility projects. By adding responsibility not only for design but also for financing and operation, P3s have significantly complicated project risk evaluation.
In a P3, a public owner typically enters into an agreement with a private developer or contractor to shift the burden of financing and operating a construction project. Contractors have long known that owners encourage them to finance construction, particularly changed work. In a P3 the contractor willingly accepts that risk of financing in exchange for an operational revenue stream upon completion. Given the current condition of the country’s transportation, utility, and educational infrastructure, P3 opportunities are poised for growth.
Under typical design-bid-build or design-build models, owners shift risk downstream to the design team and/or the contractor. Those entities, in turn, attempt to shift their risk further downstream to subcontractors, suppliers, and insurers. Problems can occur when risk is allocated to a party with no ability to control the risk. The owner is not directly involved in construction, but must assume responsibility for operation and maintenance at project completion. Any defect or deficiencies in construction must be resolved during the warranty period or, worst case, before expiration of the statute of limitations for breach of contract. P3s may work to align the interests of the owner and contractor in the outcome of the project. But P3s carry unique risks, particularly to contractors, as they require more than a keen construction acumen, and often involve financing structures, extended operations periods, management and maintenance obligations, and public interest concerns. Whereas contractors generally hand over the keys upon completion and likely have a finite warranty period for workmanship issues, a P3 requires long-term resource investment.
Assuming that enabling legislation exists for the particular P3 project, P3 contractors begin by entering into teaming agreements, or memorandums of understanding, with the other primary participants - commonly the lender/investors, management companies, and often the public entity. This initial agreement governs the relationship between these participants, from equity investment obligations to proposal preparation costs to involvement in the construction and management. Contractors must thoroughly understand the risks associated with these relationships. What capital investment, if any, is required and how is that money paid back? How are the parties sharing in proposal preparation and bidding? What level of governmental approvals is required, and who is responsible for obtaining them? Are there any unique features of the real property or project? What financial guarantees are required?
Once this arrangement is in place, the team often forms a Special Purpose Vehicle, for virtually the same purpose as the Single Purpose Entity in private development - i.e. liability protection. This SPV is formed to act as the contracting entity with the government that will procure financing, carry out the design and construction, and perform extended project operations. The contractual agreement between the government and the SPV is analogous to a prime contract, and P3 contractors must be sure to have a voice in its negotiation so as to understand the risks and how to adequately shift those risks elsewhere. Has the government clearly identified the end goals and uses for the project, in essence, provided the private entitiy a performance spec, or has the government proceeded with the project design? Particularly in the latter scenario, the contractor has expectations of design adequacy and the parties should carefully and expressly allocate responsibility for design completion.
Use of boiler plate contracts for P3 projects can also lead to risk allocation issues. For instance, many boilerplate construction agreements contain a clause requiring the contractor to comply with all applicable laws, regulations, etc. The Federal Claims Court dismissed a design-build contractor’s claims against the federal government to recover costs unexpectedly incurred because of this clause. In Bell/Heery v. U.S., the contractor argued that the government was obligated to assist it with overcoming obstacles in the state permitting process. The government relied on the contractual allocation of this risk, which required the contractor to comply with all applicable state laws, and was successful in defeating nearly $8 million dollars in claims.
Once the SPV reaches agreement with the public owner, the SPV then enters into agreements with the prime contractor and design team, either as a design-build package or separate agreements for each, operations and maintenance contractors, and other entities as necessary to complete the project. Any risk assumed by the SPV in its contract with the government should be shifted downstream or captured in insurance products, as available. As risk is allocated downstream, careful consideration should be given to allocating each risk to the party best able to control it.
Many construction issues do not develop until late in the project lifecycle, but are often a result of one party’s failure to understand or properly analyze the deal it originally struck. At that point, any costs to overcome those issues often directly reduce anticipated fees until such time as they may be recovered, if ever. Participation in the drafting process and a clear understanding of all the rights and obligations for each level of written agreement in a P3 project are vital for every participant to ensure that its associated risks are understood and within its ability to control.