Step-in Rights: How Lenders Keep a Project's Contracts

A project borrower is usually a company formed for one asset: a solar farm, a hospital, a toll road. It earns nothing except what a few contracts produce. An offtake agreement buys the output, a concession pays for availability, a construction contract delivers the asset and an operating contract runs it. The lender's security over the company's assets and shares is worth what those contracts are worth. If the counterparty to the main one can terminate for the borrower's default, the asset may be left selling into a spot market, or into nothing, and the value behind the loan leaves with the contract.

Taking security over the contract does not solve this. An assignment by way of security passes the benefit of the contract, the right to be paid, but not the obligations, and gives the counterparty no reason to wait while the lender works out what to do. The counterparty has to agree, in a document it signs with the lenders and the borrower, to hold its termination rights back and to accept the lenders in the borrower's place. That document goes by several names: a direct agreement, a side deed, a tripartite deed.

The working parts come in the order they are used. First, notice: the counterparty must tell the lenders of a default by the borrower, and of any intention to terminate, before it acts. Second, a cure period, in which the lenders may remedy the default without taking anything over. Third, step-in itself: the lenders, or a nominee company formed for the purpose, join the contract beside or in place of the borrower for a step-in period, during which the counterparty may not terminate for the defaults being dealt with. Fourth, step-out: the lenders may leave on notice, and their liability for the future ends. Fifth, novation: on an enforcement sale, the lenders may transfer the contract to a substitute owner that the counterparty may reasonably approve.

Each period and condition is negotiated. A party that steps in is usually asked to pay what the borrower already owes the counterparty, and its liability is commonly limited to obligations arising while it is in. UK government guidance on PFI contracts describes lenders there as typically having a period, often 90 days, after a termination notice to decide whether to step in or novate, and notes that stepping in may require the lenders to put in new money.

A solar farm, constructed for this page, is owned by a project company that borrowed US$58m. Its revenue comes from a fifteen-year offtake agreement with an electricity retailer at a fixed price. In year six its operating contractor fails, the plant's availability falls below the level the offtake guarantees, and the project company owes the retailer US$0.9m in shortfall payments it cannot meet. The retailer serves notice that it will terminate. The direct agreement gives the lenders 30 days to cure and then a 120-day step-in period, figures that are the example's and not a market norm.

The lenders first price what termination would cost them, on the plant's annual cash flow:

Losing the contract would leave the plant unable to service its debt from operations. Keeping it costs US$1.3m. The lenders' nominee steps in, pays the retailer, appoints a new operator and restores availability within the step-in period, funded by an advance the lenders add to the debt. When the sponsor cannot recapitalise the company, the lenders enforce and sell. Sold as shares, the company keeps the offtake; sold as a plant, the buyer takes the offtake by novation under the direct agreement, once the retailer has approved the buyer. The cash available for debt service the loan was sized on survives the default because the contract did.

Enforcement takes control of the borrower or its assets: a receiver over the company's property, or a sale of its shares under a share pledge. Step-in takes the borrower's place in one contract and leaves the company where it is. The two work together. Enforcement without step-in can hand a buyer a company whose contracts have already been terminated; step-in without enforcement buys time but changes no owner.

The lenders' right also differs from a public authority's own right, in a public-private partnership, to step into the service to keep a hospital or road running; each contract set has to settle which comes first. The same structure appears outside project finance: a development lender commonly takes a side deed from the builder, so that a developer's default does not let the builder walk off a half-finished site before the lender can arrange completion.

DEFINED IN ONE PARAGRAPH → · PROPERTY DEVELOPMENT FINANCE → · THE SHARE PLEDGE →

At approval, the credit question is whether every contract the cash flow depends on has a direct agreement, and whether its terms leave enough time to act. A cure period too short to find a replacement operator is a right on paper only. The file also records whether the lenders' liability on stepping in is confined to that contract, whether the counterparty is strong enough for its promise to hold off to be worth having, and which of several direct agreements takes priority when more than one is triggered.

Stepping in is the exception. The right does most of its work by forcing a conversation: a counterparty that cannot terminate without first notifying the lenders usually ends up negotiating with them, and many distressed projects are restructured inside the cure period. The direct agreement decides whether that conversation happens before the contract is lost, or after.

CORPORATE LENDING → · DEBT SERVICE COVERAGE RATIO → · DEBT SERVICE RESERVE ACCOUNT →