Its own worst enemy

Nick Downing is the head of non-contentious construction at international solicitor Herbert Smith. I was talking to him recently about the PFI and the Construction Act. He reckons there’s a problem looming.

Now, the PFI is a big market. Large construction companies design, build and manage capital projects, and large banks put up the huge amount of cash needed for them. The looming problem is the proposal to amend the Construction Act to torpedo “pay when certified” clauses. Herbert Smith fears that the folk putting amendments to parliament haven’t appreciated that tinkering with the payment rules could damage confidence.

Let me explain. Once the Treasury gives the thumbs-up to a PFI job, a PFI project company is formed. This employs the builders and acts as a channel for money from the bank to contractor, and back to the bank once the project is completed. Thus the project company makes a return on its investments.

Then life gets complicated. The PFI contract between the government and the project company is not governed by the Construction Act, but the building contract is. Its rules include a ban on pay-when-paid clauses.

This is embarrassing for the PFI project company. It is only a paper enterprise with no assets of its own. In return for putting up the money to get the project built, the banks, like anyone else, want to be sure they’re going to get repaid. So they try to get some cast-iron financial promises about that from the PFI company. The project company has to ensure that its expenses are always matched by a flow of cash if PFI is going to work.

The upshot of all this is that something called “equivalent project relief” (EPR) has been invented by the PFI folk to get around the pay-when-paid ban. It is a sort of pay-when-certified or entitled-when-entitled fudge. In the Midland Expressway M6 Toll road dispute, for example, EPR was supposed to prevent the contractors bringing their claim for umpteen millions to adjudication. The court said EPR clashed with the Construction Act, and allowed the contractors press their claim. What this means is that the project company could be exposed to a major liability with no assets to cover it. EPR clauses prevent this. They have become standard in the PFI market. To torpedo or move away from them is worrying; it is a significant change in a big, big business.

Nick Downing is worried that the government’s right hand doesn’t know what its left hand is doing

The snag is that pay-when-certified is also to be banned by parliament soon. This will probably mean that the project company could find itself owing money to the builder, which it hasn’t yet been paid by the Treasury. The banks are jittery about this as the project company’s cast iron financial promises could be broken.

The Treasury’s comments are not comforting. It is encouraging the project company to run its arrangements to “avoid payment mismatches”. This is probably a hint to have enough time delay between payments from the Treasury and those to the contractors to sort out disputes. Hmm! The government appears to be preoccupied with protecting the contractor’s cash flow in the construction market. Fine. But PFI is bigger than just construction. As Downing says, this is a far cry from the Construction Act’s main aim which is to protecting the “little man”.

The thinking is that we should not dampen the thriving PFI market by threatening the financial structures that underpin the deals. If the banks get nervous and walk away, PFI won’t work. What worries Downing is that the government’s right hand – the one that wants to make payment processes work – doesn’t know what it’s left hand – the one that wants PFI to work – is doing.

Downing’s point is that if it wants PFI as well as payment processes to work, it needs to complete the circle. It needs the EPR fudge or something like it – after all, that’s no worse than the insolvency exception that already exists in the pay-when-paid ban. Here’s an idea – if the Treasury wants to use a special purpose shell company, it may have to cover whatever it is liable for.

But the one thing government can’t do – and this is Downing’s point – is stick its head in the sand and pretend there isn’t a problem. That seems fair enough.