Top Ten Tips for Negotiating an LTSA

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1 Top Ten Tips for Negotiating an LTSA Jun 24, 2014 Top Ten By Thomas H. Warren and W. Jason Allman This resource is sponsored by: By Thomas H. Warren, Partner, and W. Jason Allman, Associate, Sutherland Asbill & Brennan LLP A well-negotiated long-term service agreement (LTSA) can result in significant cost-savings and improved risk allocation to power asset owners. With a number of third-party providers joining original equipment manufacturers (OEMs) in providing parts and services for power plants, the market for LTSAs has never been more robust. This ACC Top Ten highlights the top ten ways to improve the pricing and risk profile of an LTSA for owners. 1. Analyze LTSA Context, Options and Potential Leverage. When considering whether to enter an LTSA, an owner should thoroughly consider the landscape for LTSA service. Not only should the owner evaluate the OEM, but the owner should also evaluate potential third-party service providers and carefully consider whether the owner has the ability to perform these services itself. Using the OEM will provide the greatest comfort regarding parts supply and technical expertise, but this will likely come with a price premium. Third-party service providers may offer more competitive pricing and terms but may lack significant parts inventory or large personnel pools. An owner s self-performance of LTSA services may be more cost-effective in

2 the near term than entering into an LTSA, but the owner retains significant risks that a good LTSA would allocate to the service provider. Also, self-performing LTSA services may result in more unplanned expenses, and the owner may have to dedicate finite resources to managing parts supply and personnel. The evaluation and analysis of LTSA options will inform the owner s process for negotiating an LTSA, including whether the owner can effectively engage in a request for proposal (RFP) process. An RFP process significantly improves the owner s leverage in negotiations. 2. Conduct an Effective RFP Process. If an owner is comfortable with the OEM and at least one third-party service provider, the owner should carefully implement and conduct an RFP process to maximize leverage. Prior to issuing the RFP, the owner should: - Design the RFP process to fit its desired time frame, taking into account any site visits that may be necessary, any upcoming planned outages, and any necessary internal approvals; - Identify a pool of potential bidders and conduct due diligence on potential bidders; - Prepare a term sheet or form agreement and develop an objective method to easily compare bids; and - Develop a formal process for communication with bidders, including answering bidder questions. 3. Define the Term of the LTSA. An owner should ensure that the term of the LTSA accounts for the facility s current position in its maintenance cycle as well as where in the maintenance cycle the owner would like for the LTSA to terminate, e.g., whether the LTSA should terminate after a major inspection, a different inspection at a fixed date, or the earliest of multiple events. The term should also account for the number and types of inspections to be performed, recognizing that the timing of maintenance will depend on the ultimate operating profile of the units. One purpose of most LTSAs is to evenly spread the costs of maintenance over the term. Therefore, owners should take care to ensure that the LTSA does not terminate without the owner having received the services for which it has paid. 4. Determine the Scope and Pricing for Planned Maintenance. Although Planned Maintenance is arguably the most important service provided under LTSAs, owners often fail to define and describe it in a sufficiently detailed fashion. Among others, an LTSA should address the following Planned Maintenance issues: - Describe the types and number of inspections to be included as Planned Maintenance; - Specifically list and detail the services, actions, parts and other components to be provided as part of the Planned Maintenance (for instance, service providers have begun to offer parts with a useful life three times longer than the prior standard, which offers potential advantages to an owner so long as the owner receives adequate protection that the parts will perform as described); - Include a division of responsibilities for the services to be provided by the service provider and owner; - Detail the work schedule for the performance of Planned Maintenance; and - Provide the basis for Planned Maintenance pricing, which may have a number of components

3 and may be calculated in a variety of ways (such as based on the number of equivalent baseload hours or equivalent starts accrued since the last inspection). 5. Determine the Scope and Pricing for Unplanned Maintenance, Extra Work and Routine Maintenance. In addition to Planned Maintenance, the LTSA should clearly define the scope and coverage for Unplanned Maintenance, Extra Work and Routine Maintenance, including the following: - Thoroughly define what constitutes Unplanned Maintenance (which may include in-service failures and damages from force majeure or improper operation) and Extra Work; - Include a division of responsibilities and a work schedule for the performance of Unplanned Maintenance; - Set forth the basis of pricing for Unplanned Maintenance and Extra Work, which are often offered at a discount to the service provider s list prices; - Articulate whether the owner s use of the service provider for Unplanned Maintenance and Extra Work is optional or mandatory; and - Define and describe Routine Maintenance, which is typically the obligation of the owner. 6. Anticipate the Use of an Escalation Rate. Given the length of an LTSA, an owner should anticipate that the service provider may request that an escalation factor be applied to the prices contained in the LTSA. Given the sizable fees payable under the LTSA, the annual application of an escalation factor may result in significant price increases. The owner should consider whether to propose the application of a cap or collar to the escalation factor (or some other risk-sharing alternative). 7. Specify Warranties and Remedies. The warranty provisions of an LTSA are some of the most important risk-shifting provisions of the LTSA. An owner should pay special attention to the types of parts and services warranties as well as the applicable warranty periods. The warranty provisions of the LTSA should specify the following: - The scope of the parts warranties such as warranties that the parts (a) will not require replacement due to design defects or normal wear and tear, and (b) are fit for the intended purpose. - If LTSA coverage commences after a prior LTSA or self-performance, the owner should consider seeking warranties with respect to already-installed parts. - Which service warranties are being made. These warranties may include that the services performed will be (a) free from defects and (b) performed consistent with an agreed-upon standard, such as prudent industry practices. - The length of the parts warranty period (which typically ranges from one year until the next scheduled inspection) and the services warranty period (which typically ranges from one to two years). - The length of any re-warranty period (i.e., a warranty applicable to work performed under warranty). - The remedy for breaches of the parts or services warranty, which is typically repair/replacement of the non-conforming part or re-performance of the non-conforming service.

4 8. Resist Excessive Limitations on Liability. Service providers will attempt to limit their liability through one or more of the following provisions. Though some form of all of these limitations is reasonable, some LTSAs contain limits that allow the service provider to routinely invoke limitations, leaving the owner with unanticipated expenses. Owners should consider the following: - Consequential damages waiver: This provision will typically waive all consequential and indirect damages. An owner should consider whether open and close costs, downstream damages and other damages should be excepted from this waiver. - Annual and aggregate caps on the service provider s liability: With respect to both an annual cap and an aggregate cap, an owner should negotiate both the level of the cap and which types of damages should be subject to the cap (e.g., warranty damages, downstream damages, indemnity damages, title damages and termination damages). - Downstream damages waiver or cap: This provision may waive or limit the service provider s liability for the damages that a non-conformity may cause to the units (apart from the cost of correcting the non-conforming part). - Open and close costs waiver or cap: This provision may waive or limit the service provider s liability for the costs of opening and closing the units in connection with repairing a non-conforming part or re-performing a service. 9. Consider an Availability Guaranty. Some LTSAs contain availability guarantees. These guarantees provide an incentive for a contractor to keep the plant online. They can be aligned with liquidated damages payable under a unit contingent power purchase agreement or a tolling agreement to mitigate the owner s risk. Owners should note that the availability guarantee generally will only cover unavailability due to a failure of covered parts or services, not unavailability for any other reason. Availability guarantees can help align the parties interests. But they are complex and must be drafted carefully to provide fair incentives and avoid disputes over their interpretation. Issues to address include the level of damages (or bonus), what counts toward unavailability, whether all hours count equally (or periods of higher value are overweighted), and how periods when the plant is not operating for other reasons (e.g., economic reasons) are treated. Contractors will seek an availability bonus for high availability in return for an availability guarantee. A contractor-favorable availability provision that includes a bonus can often result in more upside to the contractor than downside. 10. Negotiate Termination Events and Damages. In addition to customary termination events (such as breach of the agreement or insolvency events), an owner should consider whether to include termination rights for events that are particular to the transaction or the owner s individual sensitivities (such as damages reaching the annual or aggregate cap, the failure to achieve minimum availability under any availability guaranty or extended force majeure affecting owner or the service provider). In connection with the termination events, an owner should consider what damages should be payable for termination due to the other party s fault versus a non-fault termination, taking into account not only the damages arising from the breach of the agreement but also the costs that must be incurred to cover a breach.

5 Conclusion While a number of other important provisions should be negotiated and included in any term sheet (e.g., force majeure, credit or performance security, delivery terms, and provisions related to changes in law and technology), owners can significantly improve their LTSAs, both in terms of price and risk allocation, by implementing this process and addressing the issues described above. The information in this Top Ten should not be construed as legal advice or legal opinion on specific facts and should not be considered representative of the views of its authors, its sponsors, and/or the ACC. This Top Ten is not intended as a definitive statement on the subject addressed. Rather, it is intended to serve as a tool providing practical advice and references for the busy in-house practitioner and other readers. Reprinted with permission from the Association of Corporate Counsel (ACC) 2014 All Rights Reserved.