DBRS Changes Trend on SNC-Lavalin Innisfree McGill Finance Inc. to Negative, Confirms BBB (high) Rating

DBRS Limited (DBRS) has today confirmed the BBB (high) rating of the Series A Senior Amortizing Bonds of SNC-Lavalin Innisfree McGill Finance Inc. (the Issuer), the financing vehicle unconditionally guaranteed by Groupe Infrastructure Santé McGill S.E.N.C. (ProjectCo) and its general partners; however, the trend has been changed to Negative from Positive. ProjectCo is the special-purpose vehicle responsible for the design, construction, financing and maintenance of a new 217,500-square metre hospital under a 34.3-year public-private partnership with the McGill University Health Centre (MUHC or the Hospital). The trend change primarily stems from disputed construction works, variation directives, disagreements over the deduction regime in the service phase and warning notices, the impact that these issues have had on the relationship between ProjectCo and the Hospital and the potential for further negative developments.

In 2014, DBRS placed the Project’s BBB (high) rating on a Positive trend, where it had remained until now. The change to a Positive trend from Negative was due to DBRS’s rating of SNC-Lavalin returning to Stable and the achievement of global substantial completion. The trend change also incorporated the expectation that minor deficiencies relating to construction would be rectified and total completion achieved in due course. However, since that time, final completion has yet to be achieved, and there are a number of other issues that have arisen that are unsupportive of a Positive trend, namely (1) a legal claim for $330 million lodged by ProjectCo against the Hospital, (2) a formal demand letter and an injunction from ProjectCo to the Hospital concerning deductions and failure point relief for alleged deficiencies and unfinished work and (3) the issuance of warning notices to ProjectCo as a result of failure point accumulation.

DBRS previously noted the deteriorating relationship demonstrated by a $330 million legal claim filed by ProjectCo against the Hospital for alleged scope changes and liquidated damages suffered by the Design-Build Contractor during the construction of the hospital. This lawsuit remains before the courts, and while the timing and outcome of its resolution are uncertain, DBRS remains concerned that the size of the claim and the inability to achieve a settlement short of litigation have the potential to cause lasting impacts on the relationship between ProjectCo and the Hospital.

On May 3, 2016, ProjectCo issued a formal demand letter in response to deductions that have been levied by the Hospital against the periodic service payments paid to ProjectCo for alleged deficiencies and unfinished work. While ProjectCo is of the view that the deductions relate to works undertaken as variations to the Project Agreement, the Hospital has rejected ProjectCo’s claims. The cost to complete the work pertaining to the disputed items totals roughly $5.5 million and primarily relates to heating, ventilation and air conditioning matters. ProjectCo has indicated that these works will take approximately nine months to complete. Unavailability deductions relating to the works in question amount to approximately $2 million per month and continue to be fully passed down to the Operating & Maintenance Provider, SNC-Lavalin O&M Inc. (the O&M Provider), and have not affected principal and interest payments.

On May 12, 2016, ProjectCo filed an injunction directing the Hospital to place the disputed payments in a trust account until the matter is resolved pursuant to the dispute resolution process under the Project Agreement. The injunction also aims to suspend the ongoing deductions stemming from use of the original payment mechanism. ProjectCo is seeking Hospital approval for a recalibrated service period payment mechanism that acknowledges the adjusted operating parameters of the Hospital as a result of the implemented variation directives. The recalibrated payment mechanism would provide some relief from the continuing deductions that are being levied on a monthly basis. The Hospital is currently using the original payment mechanism as part of the initial Project Agreement as a basis for applying service period deductions. While the recalibrated service period payment mechanism is currently under review, deductions continue to accumulate under the original payment mechanism until formal approval is received from the Hospital. In addition to the ongoing monthly deductions, the injunction seeks to suspend the accumulation of failure points pending resolution of the dispute and approval of the recalibrated payment mechanism. Meanwhile, the rights and security interest of the bondholders are not affected in this case, as the deductions are wholly passed down to the O&M Provider, and debt service payments have not been affected.

Lastly, DBRS has learned that ProjectCo has received three warning notices related to service-related deficiencies in IT, telecom and facility maintenance, dating back to the spring of 2015, and is concerned with the time lag between the occurrence of these events and their notification to DBRS. Pursuant to the Project Agreement, enough failure points had been accumulated to allow the Hospital to compel ProjectCo to replace the O&M subcontractor; however, since that time, the rate of accumulation of failure points has returned to moderate levels at less than half of the threshold for O&M contractor replacement. The majority of the failure points were accrued as a result of temporary and circumstantial issues affecting the availability of the building during the patient move-in period and, as such, are not directly related to the variation-related failure points currently under dispute. The accumulation of failure points is assessed on a rolling six-month basis, and accumulations have since fallen below levels that would permit the Hospital to compel replacement of the Service Provider. DBRS notes that the threshold triggering a ProjectCo event of default is well above the number of points ProjectCo has accumulated thus far. Notwithstanding, DBRS notes that these events could have had material repercussions for the Project.

In summary, while there are no immediate material credit issues, the ongoing disputes and litigation point to a difficult relationship between ProjectCo and the Hospital, which may manifest itself in additional discord concerning the fulfillment of service period performance requirements going forward, and DBRS remains concerned that recent events could ultimately strain the relationship. DBRS will continue to monitor the progress of discussions and judicial processes. Negative rating action would be likely should the judicial processes or dispute resolution procedures carry on for a protracted period. Upward pressure on the rating could result from the timely resolution of outstanding lawsuits and disputes, the normalization of relations between the Hospital and ProjectCo and a prolonged period of minimal payment deduction and failure point accumulation.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodology is Rating Public-Private Partnerships, which can be found on our website under Methodologies.