long term service agreements: the “top 10” contractual pitfalls and how to avoid them troutman...

Long Term Service Agreements: The “Top

10” Contractual Pitfalls And How To Avoid Them

Troutman Sanders LLP

Richard E. Thompson II, Esq.

richard.thompson@troutmansanders.com

Phone: 404-885-3634

Jason B. Yost, Esq.jason.yost@troutmansanders.com

Phone: 404-885-3620

LTSAs - Assumptions:

• OEM to perform all “Scheduled” Maintenance

• OEM to perform all “Unscheduled” Maintenance

• Concept of “Extra Work”

Advantages to Owner:

• Predictability of maintenance costs

• Contractually guaranteed OEM support

• Shifting of risk allocation for Unscheduled Maintenance

Source: Siemens Westinghouse

Pitfall #1

Unclear Definition of“Scheduled

Maintenance”

Typical “Pitfalls” with respect to defining Scheduled Maintenance:• definition is circular

• definition is vague• definition is open-ended

“Scheduled Maintenance” means all regularly scheduled maintenance of the Unit, including maintenance recommended by the OEM.

Definition of “Scheduled Maintenance” should include:a. List of components, and parts that

are subject of OEM obligation

b. Description of the OEM’s obligations with respect to such components and parts

c. Description of the OEM’s other obligations with respect to Scheduled Maintenance

Definition of “Scheduled Maintenance” should include:d. List of what, if anything, is NOT

included in the OEM’s workscope

e. “Catch-all”

Pitfall #2

Not clearly defining “Extra Work” concepts

and cost allocation

“Traditional” concepts of “Extra Work”

• optional• separately

priced• limited limitations of liability• limited warranty

“Extra parts or labor to perform scheduled maintenance that becomes required as a result of Owner’s operation of the equipment in a manner other than as expressly assumed in this agreement shall constitute Extra Work.”

Step 1: Unblending of Concepts

“Extra parts or labor to perform Scheduled Maintenance that becomes required as a result of Owner’s operation of the equipment in a manner other than as expressly assumed in this agreement shall constitute Extra Workare not included in the Scheduled Maintenance Payments. Owner shall pay OEM for such parts and labor based upon the pricing set forth in Exhibit X.”

Step 2: Properly Defining Extra Work

“Extra Work shall be all work performed by the OEM that is not within the scope of its obligations under this Agreement (i.e., not Scheduled Maintenance or Unscheduled Maintenance) and that has been agreed to prior to the time it is performed.”

Pitfall #3

Inappropriate Allocation of “Prolonged” Start-Up

Risks

Prolonged start-up under the Equipment Purchase Agreement can lead to the accumulation of an inordinate number of pre-cod Factored Hours and/or Factored Starts under the LTSA

In no event shall pre-COD hours and starts caused by a defect in the Equipment be charged to Owner”

“16. Credit for pre-COD Hours and Starts.

Pitfall #4

Failure to Protect Owner Interests in the

Absence of Performance Guarantees

Performance Guarantees are often formulated to

address: • Bonus/penalty for Outage

time (both Scheduled and Unscheduled)

• Overall availability

Contractual Requirements in Lieu of Performance

Guarantees: •mandate a given response time for

unscheduled Outages•set maximum Outage time

requirements for Scheduled Maintenance Outages

•require that the OEM’s services be provided in a manner that generally ensures a minimization of unscheduled Outages for the sake of overall plant reliability

Owner Remedies in the Event of OEM’s Failure to Perform:

• self-perform (and backcharge OEM)

• right to terminate the contract

Pitfall #5

“Illiquidity” of Parts

Summary of Typical LTSA Provisions:• “Title to Parts will transfer to

Owner upon delivery to the Site.”• “All Parts will be warranted against

defects for one year after installation into the Covered Unit.”

• “Owner cannot assign its rights or obligations under the Agreement without OEM’s consent”

Possible Pitfall: Owner wants to transfer and use Parts from one of its facilities to another.

Issues: Owner has title, but:+ Warranty language is specific to

the defined “Covered Unit”+ OEM must consent assignment= “Illiquidity” of Parts

Possible Solutions:• Draft warranty language so that it

is not “Covered-Unit”-specific. (e.g., “Part is warranted for 1 year after installation into any unit)

• Allow for assignment of warranties to affiliates without prior OEM consent

Pitfall #6

Entering the “Absurdly Long” Long Term Service

Agreement

The “Term” of this Agreement shall begin upon Commercial Operation and shall expire upon the completion of:• the second Major Inspection on the Unit• completion of the 4th Hot Gas Path Inspection • 96,000 hours/3,200 starts

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Major Inspection

“In the event the Unit has not reached its second Major Inspection within 13 years after the beginning of the Term, then this Agreement shall terminate.”

“44. Termination after 12 Year Date.

In the event the Term of this Agreement reaches 12 years and the second Major Inspection has not occurred, Owner may terminate this Agreement after the completion of the next Hot Gas Path Inspection after such 12 year period.”

Pitfall #7

Limited OEM Obligation for Last-Installed Parts

End of Term Issues to Consider:

• What quality of parts will be installed in the equipment at that time?

• What obligations will the Contractor have with regard to those parts after the LTSA expires?

Incentives During the Term for the OEM to use “Top

Quality” Parts:• OEM responsibility for

Unscheduled Maintenance costs• Liquidated Damages• Availability Guarantee

“All parts installed at the second Major Inspection shall be

warranted to last until the next “regularly scheduled” inspection

at which such parts would be replaced in their normal life

expectancy.”

Pitfall #8

Not Allowing for Early Cancellation of LTSA

“22. Termination for Convenience.

Owner may cancel this Agreement for its convenience at any time upon notification to OEM.”

“23. Right to Terminate Without Cause.

In the event Owner elects to terminate the Agreement in the absence of an OEM Default, Owner shall pay to OEM the sum of ….”

“24. Right to Re-Negotiate Pricing.

After the first Major Inspection, the Parties shall meet and, in good faith, re-negotiate the pricing of this Agreement to ensure that it is equal to or better than pricing available to Owner under a “self-performance program.” If the Parties are unable to agree on such pricing, then Owner reserves the right to terminate this Agreement.”

Pitfall #9

Failure to Consider State Tax Law Ramifications

Important State Tax Considerations

Taxes of sale of Parts

Taxes on services

Taxes on “use” of Parts

Real property vs. personal property

Depending upon applicable state tax law, various tax minimization strategies may be available:

• Complete bifurcation of contracts between Parts and Services

• Separation of OEM entities providing Parts and Services (under same LTSA, but with separate invoicing)

• Positions regarding refurbishment of a Part constituting a Service

• Advantages found in clarity of pricing as between Parts, Services, M&D, risk-allocation premiums, etc.

Pitfall #10

Dangerous Limitation of Liability

Clauses

“46. Limitations of Liability.

OEM’s total liability under the LTSA shall be limited each year to the amount paid by Owner to OEM in the previous year.”

3rd Party Owner

Contractor

“46. Limitations of Liability.

OEM’s total liability under the LTSA shall be limited each year to the amount paid by Owner to OEM in the previous year.”

“47. Carve-Outs from to LOL. OEM’s liability for third party claims shall not be subject to the LOL in 46 above.”

LTSAs: Top 10 Contractual Pitfalls And How To Avoid Them:

1.Clearly Defining “Scheduled Maintenance”

2.Clearly defining “Extra Work” concepts and cost allocation

3.Appropriately Allocating “Prolonged” Start-Up Risks

4.Protecting Owner Interests in the Absence of Performance Guarantees

5.Preventing “Illiquidity” of Parts

LTSAs: Top 10 Contractual Pitfalls And How To Avoid Them:

6.Negotiating an Extended End-of-Term Parts Life Warranty

7.Avoiding the “Absurdly Long” Long Term Service Agreement

8.Allowing for Early Cancellation of LTSA9.Considering State Tax Law

Ramifications10.Structuring Appropriate Limitations of

Liability and Exceptions