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AI-NOU-1998 15:45 FROM &3Y FF PFI TO sa904630 P.O1
F/ = Corporate Financo 4
@ BV ErRnsrzYounc Compote Fi
Fac
y-Lambath Palace Road COE & LOE Box
Londen $1 760
Fax Message
For the attention of Tim Brown Date 1) Nov 98
POCL “No. of pages
Company (including this)
Fax number
From Marcus Holden Sorlal No.
Direct Fax number
Direct Telephone number
if there are any problems with this transmission please contact the fax operator.
Dear Tim,
We have now completed a more detailed review tation that you gave us, and
have developed our thoughts on both the accoyfting implicationy of the proposals and the
more pertinent commercial implications bascd/6n camparison te’broudly similar projects (or
at least comparison to PFI projects generallyard the it Treasury Guidance).
Accounting - Measures for Balance Sheet Trea’
Change in project since our initial rev
The broad message from our initial revit conducted under FRS5 and SSAP2! analysis)
was that POCL took little of the-risk/rewarWof ownership of the project assets, and therefore
was unlikely to have an int
the fact that POCL was ag g y/runction for the Benefits Agency, and was not
exposed to factors such
* A inajor part of this Pat the bulk of the transactions handled by the system
were BA related, 4 some - at the time relatively undefined - element of
benefit transferrg a kesult of their being able to utilise the system for their own
purposes. Froni of} iong/this is certainly no longer the situation. There is significant
from day one, and by the end of the project there is no
envisaged usage by the BAD
This by itself represents a significant change in the assessment of the treatment of the project
* from the POCL point of view. It will certainly result in far more risk being taken for the
‘This tax may centain confidantial information for tho addrozsco(a) only. It a transmission error has misairectod tha fax, plaaso
notity us on! ittell-tree « UK only) or! (international), then destroy the fax communication, Wo
will raimbu ernational calls, You fisclose, distribute cr capy thic communication, Thank you.
A copy of the original fax s stored for a paried by Emst & Young.
Alist of partnors' eames Is available for Inspection at tho above addrass, the partnershio's principal place of business.
Authorised by Tho Institute of Chartored Accountants in England and Wales to carry on Invastment business.
Tho United Kingdom firm of Emst & Young is a member cf Emst & Young Intemational,
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assets and will start to tip the scales from the previous clear cut assessed position. However,
this in itself is not a significant issue with regard to the final treatment of the assets -
obviously most PFI projects will result in some risk to the public sector party, and this
element is only one part of the jigsaw.
New applicable standard
The new applicable standard of relevance in this case is the amended FRSS, which includes
an application note specifically addressing PFI issues. Where non-separable payments made
by a purchaser fall into both service and asset provision categories (as they will in this
instance), the FRS is clear that it is the applicable reference, and the relevance of SSAP21 is
significantly diluted, .
In determining the nuture of the asset, and its treatment by the purchaser, the FRS notes there
are several ‘property risks’ that will be relevant:
“As noted in paragraph F19, in applying the
bear any variations in property profits (0;
je key test is to establish who will
° demand risk (see paragraphs F24-F3
. the presence, if any, of thi
° who determines the nature o: eopeity (see paragraphs F35-F37)
. penalties for undepp
eS potential change!
a obsolescence_inclu:
and F43) Van
¢ the
F44-F48).”
end of the contract and residual value risk (see paragraphs
It states that it is:
“{mportant to assess the effect of all relevant factors and the interaction between them,
giving greater weight to those that are more likely to have a commercial effect in
practice.”
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I Within these property risks, the ones seen as key by ourselves, are the demand, third party
revenue and residual value risks, but the technology risk may also be key in IT application
Projects.
Impact of ‘Revised Offer’ terms:
Third party revenue risk
There is no third party revenue.
Technology risk
Technology refresh cost risk is presently lying with POCL. This is a significant area where
ICL might have been expected to take the ‘technology’ risk. The FRS is clear on this point:
technology are significant, the
its will be the one for whom there is
“Where the potential for obsolescence or chan:
party that bears the costs and any associated be}
evidence that the property is its asset.”
Demand risk
The level of guaranteed transactions (and
in relation to the allocation ° of demand
nue to Pathway) may give problems
FRS states that the initial question is
re is significant uncertainty over
future demand levels the allocation of gh xh assessment of asset ownership.
Assessing the risk in this case would See how realistic the tabled estimates of
future demand/transaction volumes ar d then considering whether the provided
guaranteed minima against th: alloys a reasonable level of risk transfer. In our
Hat uppear too high - further reducing the likelihood of
ent streams.
Residual value risk
Pricing of asset transfer at the end of the project should ordinarily include an element of
residual value risk to the private sector. Such residual value risk will ordinarily be
demonstrated by the financial model (on which the project pricing is based) including
significant residual value which the sponsor will not be required to pay, and thus a
commercial risk exists of such non-payment.
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This highlights a problem inherent in projects of this nature, that the residual valuc outside of
the contract is nil, and therefore the realistic level at which to set the price of transfer is also
nil. This implies that the purchaser has paid for the asset over the life of the contract, which
in tum is an ‘on-balance sheet’ indicator. However, allowance must be made for this
Situation in assessment of the position. Further indications should be sought, that might
include how the purchaser ensures the asset is delivered in acceptable form and state of
operational repair.
Initial pricing risk
The ‘contingency’ element definitely appears to remove much risk from Pathway for primary
items such as project slippage during the construction phase (as now extended). This is a key
indicator that POCL retain the risks of ownership.
Balance Sheet Treatment - Conclusion & Impact
ications of the extent of the ‘Revised
full evaluation of the position
={ ¢ project would become
‘on-balance sheet’ to POCL. This has been prj ly impacted py the fact that there appears
little transfer of the demand risk to Pathway, will be fully paid for over the term of
Notwithstanding that we have only been given rough ff
The impact of this conclusion is that
its balance sheet and depreciate the ass:
end of the concession, with some accoun
to be a corresponding liability in the bal:
asset over the term of the cos
over the term, ‘and there
interest payment implied Sy
ccount for the systems as an asset in
he Usenil economic life (ic the period until the
ofthe technology refresh). There will need
sheet, representing the liability to pay for the
en. This’ irAbility will be released as payments are made
a n additional profit and loss charge to reflect the imputed
Contract Terms,
We have also conside) act of the ‘Revised Offer’ terms in light of the draft Treasury
Guidance, and also other ‘pe PFI deals of which we are aware, in order to provide some
insight as to whether the terras proposed appear reasonable. Obviously overall judgements as
to must be taken in the round and as part of the final contract as a whole
FOTAL P.O<
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n\wgstod “eto “ON RUEL ° sztet 86, TT/IT a Ier\ eT
Cory SLAUGHTER AND May &L NOV 1998
Sconce, 35 ae Street. Lond
Vordn Telex!”
Veet
FAX TRANSMISSION
91035 = Nov 11~13:08
Date 11th November, 1998 Document number — CA983150.056
In cenly pleare quote = JRT Total pages (ine. this) a
From Jeff Triggs Writer's telephone
To Catherine Churchard, Post Office Legal Receiving fax number -
Services, Croydon
Copy to Jonathan Evans, Post Office Counters Limited, London
Paul Rich,.Post Office Counters Limited, London
Mena Rego, Post Office Counters Limited, London
Lesley Lawson, Post Office Counters Limited, London
Nick Gray, Slaughter and May
Hamish
Once.again, when I read Hamish’s letter to you of 10th November I feel like the little
boy staring at the emperor's new clothes. - .
The conflict issue seems to me entirely clear and simple. The fact is that in certain
areas we would like Hamish to do one thing and DSS would like him to do another. For
example, we would like him to promote Option 1 and stress the veto right in Contract B,
whereas DSS would like him to promote Option 2. Option 1 and Option 2 are mutually
“incompatible.
Faced with such different objectives it is not Hamish’s job to steer a fair and reasonable i
middle line and to do what he thinks is best for the public sector parties as a whole. It is his :
obligation to stand down and not involve himself in this area. That is crystal clear.
The professional conflict of interest rules which bind solicitors are there because in
circumstances like this it is neither desirable nor possible for a lawyer-to steer an impartial
middle course.
The view of this morning's meeting (at which Stuart, Jonathan and Mena were not ij
present) was that of the options cited in your memorandum only 3 and 4 were likely to be .
acceptable to POCL and that 3 was really the only practical solution. Even then it would need
THIS FACSIMILE IS CONFIDENTIAL AND MAY CONTAIN LEGALLY PRIVILEGED INFORMATION. IF YOU ARE NOT NAMED ABOVE AE
AN ADDRESSEE IT MAY BE UNLAWFUL FOR YOU TO READ, COPY. DISTRIBUTE, DISCLOSE OR OTHERWISE USE THE INFORMATION
IN THIS FACSIMILE, IF YOU ARE NOT THE INTENDED RECIPIENT OF THIS FACSIMILE PLEASE TELEPHONE OR FAX US IMMEDIATELY.
‘list ofthe pariners and their professional qualifications 1s avalable for inspection atthe above address.
‘The partners are either solicitors or registered forcign lawyers,
If you do not receive all the pages, please phone!
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careful thought as to the practical constraints as to who secks advice from Hamish and on
what subjects.
Regards __
JR Triggs
i
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veTiesa 11240 FROM-JHS PROJECT FINANCE
as
Fes7e I P.Oi/DE F730
=
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FACSIMILE MESSAGE
To: Tim Brown Number of Pages: 6
Financial Convoller
Post Office Counters Ltd
From: Date: 11 November, 1998
GESTS Pay Sones Page Had canhaennn Pntormesiog Sno fe Tatended Zr whe escresce Only, LEFT Tender i bot Gre Adktrestoc Of Hit
<eaployes oF Mpent you Ate Eeteby pOttied iat any diéslasuce. dlsverainstion o5, coming of the comients iy pniiaited Ifyou nave rere
his fax in error, please notay um imcacdunely end reuan Gx enginal by malt :
in.cute of any probleas with the transmits!
simile please telephone
‘Michelle Read on! ; "
oct / Pathway
Further to your meeting and conversations with Andrew Cox earlier this werk attached are
bref camments on ICL's 5 November prop:
As requested we have focused on points of interest to lenders providing Limited recourse
fimds to Pathway. However, you should nove that the specific terms acceptable to Tenders in
the areas covered by ICI."s documents will depend on the overajl terms of the contracts, the
tisk allocation, the level of support provided by 1CL/Fujitsu” in respect of Pathway’s
Obligations and the general conditions prevalent in the market, particularly for PFE projects, at
the time lenders are approached. Our comments should therefore be vicwed a3 indicative
only. : .
‘Ata more general level, we would further note that the assumption that a substation amount
‘of debr cauld be raised on a wus limited recourse basis for Pathway is questionable, The
appetite of lenders to take significant tisk in the area of IT is not proven with there being
recagnition thar it is not an area which Is easily “banked”.. The propose] from ICL suggests a
high level of recourse for the banks to the public sector. This removes risk direedy from
ICL/Fujitsu, which is currendy providing @ corporate guarmice for Pathway's debr. Since
Jenders* requirements will depend on their view of the project economics and contracted basis
at a detailed level it may be more appropriate to include only a sentiment relating to mind
recourss finance at this stage rather than to agree a specific list of terms which may be 100
generous or indeed insufficient for the purposes ofraising debt financing.
Please call me ta discuss further, as you wish.
6 Furnceay, ESN]
— Prema
Relying oN Woh wows
— ss Pasthnted je fy enero
: i _ a jequiated by SFA 7. Henry Sei Ca, Limited
Fastin i. __GRO_ 4 . neaviet nd - 120 Ghee ‘Londen EC2V 6DS
Telex Londen 885029 . {paren oifice Ds anova Redroo
fegsuates number 532081 Engtand
ty feed Kae ddail
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Tete I P9206 I F306
‘The Post OfficeACL Pathway
Comments on ICL 5” November proposal
i. HEADS OF AGREEMENT
General
LS
The PPP agreement is intended to desecibe the way that the POCLACL PPP will
work: together towards realising New Business Opportunities. Althoush the
document declares that it is not legally binding. the tone suggests thet it is paving
the wzy for 2 more formal parmership agreement at 2 Jeter date. Is this POCL’s
intention?
Is it POCL’s intention to recruit a new parmer with financial serail experience?
This points towards a more forma) partnership than envisaged.
TE this document is ta be entered into by POCL, the terms of the Related
Agreements should be agreed prior to signature. This clause appecrs to be an
attempt to bulldoze ICL’s stated ‘commercial position through the PPP.
$3
This would appear to be a back-door attempt by ICL to get pre-emption tights
‘upon any future POCL privatisation. Has this been the subject of nny negotiadon?
2.1 Gv)
2. COMMERCIAL AND CONTRACTUAL PROPOSALS
Are these the current volume of tansactions forecast by the
POCL guarantee runs off the forecast transaction volumes,
that these figures sre accurate, and preferably, conservative.
2.1 (vt)
Ts the PINPADS funding supplementary to whet was anticipated as the “refresh” in
the original contract?’ Ifso, how much is it, and when does it take place?
3.1 Gy
What is the valuc of the 80% transaction guarantee in comparison to the asset
acquisition offer? Any valuation should also fnelude the valuation of the
contingency, which stems ta be sole POCL risk. From where has the 80% figure
‘been derived, is it just to improve returns and bankability? Why is the proposal for
banking wansactions higher than for the care businesses?
Liquidated Damages: This results in POCL effectively being responsible for a
proportion of LDS as it is funding the contingency fund. Only if the contingency
fund is exhausted does Pathway become liable. Normally, the contractor would be
responsible for performance over-runs/delays prior To Acceptance.
3.1 Gv)
{€ 9 Direct Agreement is conceded, all termination rights will be subject to rhe
banks’ rights of step-in.
3.1 (viii)
Yf he LDS for delay are to be removed, then funding for delay will be through the
contingency, which effectively makes deloy 2 POCLE risk, Presumably this fs not
the intention?
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3-1 (xi)
The ailditional value (if any) should be agreed in advance between Pathway and
41
‘The “blame culture” presumably refers 10 a “xormel” project finance tisk
allocation mechanism (LDs for delay/non-performence ¢1c.), which will likely be
required by banks fimding on a limited recourse basis, so that the party responsible
is comractually obligated to take the non-performance risk.
In this proposal, Pathway relies upon the contingency fimd for overruns/non-
performance and the Authorities fund the contingency. If the contingency is not
Tequired, POCL only receives 33% back. This would appear iniquivous as far 2s
POCL is concemed, on the face of it. ‘
45
See comments on 4.1 above.
6.3
Is this contract the Heads Agreement or is a further agreement proposed?
6.2
Tf there is a single interface berween Pathway and POCL, POCL will need to be
careful to “back to back” risks taken under the Pathway contract with the DSS/BA
under the services relationship agreement (or whatever contact ia put in place).
POCL will be sandwiched berween Pathway and the DSS/BA and undue pressure
could be bought to bear from bath sides, ifnecessary-
Attachment 1
Ts the RPI indexation -3.4% or -2% from 1999? Is ICL now willing to accept an
NPV of -£103m?
Amachment 2
Does the contingency cover Pathway non-performance? If not, how does Pathway
cover this risk? . a
1.2
3. PATHWAY FUNDING PAPER.
See comments on 6.2 ahove.
1.3
These are issues that should only be addressed once terms are negotiated with the
jenders. The need for security anda Direct Agreement will ‘become apparent once
the commercial terms are agreed and the allocation of riskS in the project can be
fully appreciated. Lenders would typically seek to take security over al] assets that
are available and can be given as security by the project company. A Direct
Agreement is not unusual but would only be insisted upon if there were concems
‘over the termination regime negotiated between the pasties. (c.f. coroments on the
Direct Agreement below) i
i)
We need to clarify the timings of this termination payment Does this mean
“after” or “during” National rollout? .
3.1
Lenders with wantto see risks being allocated through agreed contractual remedies
which is POCL funded. Whar happens on Pathway default?
3.1 Gi)
(Ds etc.), Ths only contractual remedy eppeats to be the contingency fimd,
We need to clarify the nature of these defaults. POCL should inaist on wltmately
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having termination nights Jor material Pathway default.
3.2@) ‘This is semantics — " jstent and material breach of a material obligation” —
POCT. should have unequivocal rights of termination for material Pathway breach.
Other defaults should be included.
3.4 Even if POCL accepts no jermination rights on change of conto}, POCL would
want natice and possibly cansent rights over any change in shareholding. Lenders
will likely insist on a change of: comtrot mechanism anyway.
42 Presumably gueranteed payment volumes should decrease commensurately with
the partial termination? ®
510 ‘In what circumstances could POCL be required to fund this amount in onc g0?7
5.1 Gv) This should be referenced as without prejudice to any security rights that POCL.
may have. '
62 (i) If POCL pays the equity and the forecast. return, there js no equity risk. This is
efféctively 2 POCL guarantee of the whole project eopital.
6.2 BY Yt is inconsistent that POCL should bear the whole debr burden of Pathway default.
6.2 iii) Why is POCL paying the debt ouran rermination for Force Majeure?
71@ This effectively gives Parhwoy ynilateral rights to determinc the project
specification. Both parties should be required to agres te changes in the project
spec.. Landers may also require consultation rights if there is going to ‘be an
impact upon the funding requirement.
7A Ga) ‘This puts all change funding risit on POCL and should be resisted.
7.1 (iii) If POCL is to take change in spec. risk, payments should be made against a pre-set
milestone schedule, rather than being a onc-off capital payment. -
7.4 Gv) Le. POCL wkes the risk in the end.
Tw) - Operating risk shauld be with Pathway, not POCL, otherwise there fs no incentive
‘on Pathway to operate the system cfficivatly.
mY ‘The Guidelines stipulate that change in law risk should be built in to the bid price.
POCL should not take all change in law risk. Pathway is beer placed to assess
certain change in law risk ¢.g. IT change in law risk.
9.4 ‘This is vague and needs to be clarified.
10. See general comments on the Direct Agreement below.
La sec comments an lenders above (clause 1.3)
JEPOCL refreshes in 2006, then its £100m investment will automatically form part
of lenders’ security over Pathway assets. POCL will nced to ensure that the
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Tekeshment assets are carved out trom the banks’ security net.
12.1 ‘How about if a corrupt gift is provided with Pathway's connivance? This should
be Pathway risk (c.f. 12.2)
172 Jris understandable that the lenders may sequire credit enhancement upon 2 change
in control or identity of the Authority (e.g. upon privatisation). However, the
mechanism for achieving this should be addressed at the time and POCL should
not be ted in to purchasing credit enhancement insurance at this smge.
4. ACCEPTANCE
General Generally, the burden of delivering a product to an agreed specification should
with the contractor and the client should have rights to accept or reject the system
‘by measuring the performance of the system against pre-set performance
benchmmks. An independent expert may also be involved in this process {in this
case, the Expert). In addition, the lenders may ‘also wish to appoint their own
expert. POCL should not be obliged to accept the system and should be entitled to
Jook to the contractor for compensation (LDs ec.) in the event that the
performance of the system is unacceprable. Accordingly, we would not expect
Tevenus payments to be made to Pathway ‘umil the system bad been unequivocally
accepted by POCL.
2) POCL should be involved in determining whether Acceptance is achieved or not,
especially if termination rights cease on Acceptance. If termination vights do not
arise on non-Acceptance, damages should certainly ‘be payable. POCL should also
have rights to determine whether the non-Acceptance justifies starting Live Trial
Ase all costs incurred during the proposed extended Live Trial pesiod to be funded
from the cantingency?
3.1 @ Presumably, POCL should retain rights to certify e Relesse.
4.1 Gi) POCL should agree the identity of the Expert.
&, DIRECT AGREEMENT
General ‘This looks like the Treasury standard Direct Agreement,
Ym this document POCL acknowledges the banks” prior security interests and
defers POCL’s rights of termination during the Step-in Period. As soan as notice
is given to the Agent, the Agent may procure thet an official representutive
assumes all the contractor's rights under the contract «md this marks the start of the
Step-in Period.
Tt is nor unusual for banks to request a Direct Agreement to allow them to step-in.
in edvance of any other interested party to try to preserve their position vis-a-vis
the borrower (for example, by introducing 2 Substitute contractor to complete the
project so that the company can shart generating revenue to repay the debt). tris
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the outstanding debr.
‘gencrally nat in the banks” interests to see the project terminated as this deprives
the project of revenue-generating capacity and means that the banks have to rely
on, and enforce, their physical security, which may not be sufficient to discharge
However, as a negotiating point, POCL should not concede the requirement for a
Direct Agreement with the banks until the whole cammerciel package (particularly
the termination regime) is agreed, and only then if absolutely required.
ICL
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