1. Richard E. Thompson II, Esq.
Long Term Service Agreements: The “Top 10” Contractual Pitfalls And How To Avoid Them
Troutman Sanders LLP
Richard E. Thompson II, Esq.
Phone:
Jason B. Yost, Esq.
Phone:

2. OEM to perform all “Scheduled” Maintenance
LTSAs - Assumptions:
OEM to perform all “Scheduled” Maintenance
OEM to perform all “Unscheduled” Maintenance
Concept of “Extra Work”
Long Term Service Agreements, Long Term Parts Supply Agreements, Contractual Services Agreement, Long Term Maintenance Program Agreements…though they go by many different names, long term service agreements are all essentially about the same thing –
It is a “long-term” service agreement whereby the original equipment manufacturer (OEM) will provide maintenance services for your gas turbine and/or steam turbine (both scheduled and unscheduled), over a long period of time, at a relatively fixed price. And, some concept of “Extra Work”

3. Predictability of maintenance costs
Advantages to Owner:
Predictability of maintenance costs
Contractually guaranteed OEM support
Shifting of risk allocation for Unscheduled Maintenance
Commercially speaking, LTSAs can offer many advantages to Owners. These include the predictability of “relatively fixed” long term maintenance costs, as well as contractually guaranteed or even incentivized OEM support and finally, the potential for shifting the risk of unscheduled maintenance.

4. Source: Siemens Westinghouse
In fact, one OEM has indicated that, at least with respect to its units, gas turbines covered by a long term service agreement have a higher overall availability over their life-cycle than gas turbines not supported by an LTSA.
However, if you are not careful when you negotiate your LTSA, you may find yourself at the bottom of one of the many pitfalls that await unwary Owners.
Today, we’d like to talk to you about what, in our experience as lawyers drafting and negotiating these contracts on behalf of our clients, we consider the “top 10” of these pitfalls, as well as some ways that you can avoid these pitfalls altogether and, in the long run, save yourself time, money and one big headache.
Source: Siemens Westinghouse

5. Pitfall #1 Unclear Definition of “Scheduled Maintenance”
“Scheduled Maintenance” typically deals with the Contractor providing all of the parts and labor necessary to perform all regularly scheduled maintenance inspections on the equipment - such as inspections on the combustor section and the hot gas path section. Well it sounds simple enough.

6. Typical “Pitfalls” with respect to defining Scheduled Maintenance:
definition is circular
definition is vague
definition is open-ended
But what happens when the contract is not entirely clear on “what” is included as part of the Contractor’s scope of work? The resulting uncertainty can pose major unnecessary headaches for both Owner and Contractor.
While it would seem like this fundamental concept of an LTSA would be relatively easy, we have seen examples of scheduled maintenance definitions that are vague, circular or open-ended. For example,

7. “Scheduled Maintenance” means all regularly scheduled maintenance of the Unit, including maintenance recommended by the OEM.
The language here is a prime example of all three problems that can arise when one is not careful in defining scheduled maintenance. For instance:
“all maintenance that is scheduled
“all maintenance that the OEM recommends
“all CI, HGP and Major Inspections”
This definition is a contractual dispute just waiting to happen.
[Now while it is easy enough to identify what the contractor is supposed to do (e.g., perform all necessary inspections on the equipment)…vagueness in defining HOW the Contractor is supposed to perform these inspections can result in a degree of uncertainty and unintended consequences…]

8. Definition of “Scheduled Maintenance” should include:
List of components, and parts that are subject of OEM obligation
Description of the OEM’s obligations with respect to such components and parts
Description of the OEM’s other obligations with respect to Scheduled Maintenance
b. see slide
c. see slide. Consider using a detailed list outlining everything from “pre-shutdown checks” to “mobilization obligations” to inspection obligations” (don’t forget “inspect-only” components).
d. see slide - repairing, replacing “inspect-only” components; or replacing Operational Spare Parts that would not normally be replaced during a “Scheduled Maintenance” outage.
e. see slide. Whatever those might be. For instance, it may be “98% availability,” or “maximizing revenue” or even “minimizing the number of unplanned outages.”

9. Definition of “Scheduled Maintenance” should include:
List of what, if anything, is NOT included in the OEM’s workscope
“Catch-all”

10. Pitfall #2 Not clearly defining “Extra Work” concepts and cost allocation
A second common LTSA pitfall, involves the concept of Extra Work. While the “standard” concept of Extra Work is intended to be simple and straightforward, this simplicity can easily be shattered when additional concepts are forced under the rubric of an Extra Work definition.

11. “Traditional” concepts of “Extra Work”
optional
separately priced
limited limitations of liability
Optional – non-scope items (repairing or replacing “inspect-only components such as condensor or boiler feed pumps, or thermocouples (from our previous example))
Separately - Priced and paid for completely separately, (by the drink) usually through a “work order”
Limited Warranty – usually one year
Limited lol – usually the price of the Extra Work performed.
This was fine as intended. But a problem arose when parties began including work that actually IS in the OEM’s scope, but not PRICED into the contract price, as Extra Work.
Here is an example of what I mean…
limited warranty

12. “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.”
This “pretty standard” definition of “Extra Work” is one that we have seen in many LTSAs. And while it seems reasonable, the problem is that it has mistakenly been crafted so that it includes the provision by the OEM of extra parts or labor that become required for the OEM to perform its “normal” scheduled maintenance work scope. There is an internal inconsistency present by defining certain scheduled maintenance as extra work.
Let me give you an example, say you have a plant that operates by the ocean. Now, as we all know, the risk of corrosion on your turbine as a result of the salt in the air is likely to lead to an extra combustion inspection being required.

13. 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 Work
are 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.”
First, to avoid this pitfall, the parties must avoid blending the “standard” concept of Extra Work with the concepts of “scheduled” and “unscheduled” maintenance. All of these concepts should be kept separate and distinct from each other, and the parties should strive to keep the definition of Extra Work short, simple and separate so that it applies only to optional work that is not included in the OEM’s “normal” maintenance work scope.
The LTSA should describe in detail the basis for pricing any such parts and labor. This may very well be the same mechanism for pricing actual Extra Work. The language may be repetitive insofar as these two pricing bases may be parallel; however, the resulting clarity will be well worth such repetition.

14. 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.”
Secondly, now that the concepts are indeed separate, the Parties should clearly and succinctly define Extra Work so that it ONLY covers that work which is indeed “extra”

15. Pitfall #3 Inappropriate Allocation of “Prolonged” Start-Up Risks

16. 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

17. “16. Credit for pre-COD Hours and Starts.
In no event shall pre-COD hours and starts caused by a defect in the Equipment be charged to Owner”
Is ensuring that equipment defects under the Equipment Purchase Agreement will not be charged to the Owner when it is time to calculate the first invoice after COD.

18. Pitfall #4 Failure to Protect Owner Interests in the Absence of Performance Guarantees
So you have finally gone commercial, things are running smoothly and you are in the middle of your peak period when all of a sudden…

19. Performance Guarantees are often formulated to address:
Bonus/penalty for Outage time (both Scheduled and Unscheduled)
Overall availability
Oftentimes, this is accomplished through contractual guarantees. Performance guarantee provisions normally provide financial incentives (e.g., bonuses and/or liquidated damages) that help ensure that OEM response time for unscheduled outages is immediate, that outages (both scheduled and unscheduled) are completed quickly and efficiently, and that the reliability level of the equipment is as high as possible. But what if your LTSA does not have any performance guarantees? Oftentimes, especially in today’s market, project economics do not allow them? Are you destined for a pitfall? Not necessarily.

20. 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
Owners can avoid such pitfalls by insisting that their LTSAs establish contractual requirements for OEM behavior, with clear, non-financial remedies if such requirements are not met.
Read slide
First bullet - e.g hour response time
Second bullet - e.g. CI’s must be complete within 7 days
Third bullet - For instance, the parties can agree beforehand on a plan and a time during which the unscheduled maintenance is to occur.

21. Owner Remedies in the Event of OEM’s Failure to Perform:
self-perform (and backcharge OEM)
right to terminate the contract
And don’t forget to include remedies in the contract that would allow the Owner relief in the event that the OEM does not meet the requirements.
For example: read slide

22. “Illiquidity” of Parts
Pitfall #5
“Illiquidity” of Parts

23. 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”

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

25. Issues:
Owner has title, but:
Warranty language is specific to the defined “Covered Unit”
OEM must consent assignment
= “Illiquidity” of Parts

26. 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

27. Pitfall #6 Entering the “Absurdly Long” Long Term Service Agreement
So you have negotiated and signed your LTSA and your plant is commercial. You have protected yourself with respect to the types of parts that you will be getting at the end of the term…

28. 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
Oh sure, you have negotiated a “Term.” But chances are that your “term” is not likely to be based on a set number of years, but rather may be based on “hours of operation” or “starts” or even “maintenance events.”
While all of these parameters are intended to insure that the “term” of your LTSA accurately tracks maintenance as it related directly to operation of your Unit, there may be an unintended consequence that could come back to haunt you down the road. For example, let’s say that an Owner anticipates a baseload operating profile, with operation of approximately 8,000 hours per year.

29. X
Major Inspection
(End of Term)
Major Inspection X
Hours of Operation
Years

30. Major Inspection
(End of Term?) X
Hours of Operation
Years

31. “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.”
One approach is to have a “sunset clause” whereby the LTSA term will automatically expire after a given anniversary (e.g., 13 years) of the initial commercial operation date of the equipment.
But, beware, such a clause, while better than nothing, does come with a few problems of its own. For instance,

32. “44. Termination after 12 Year Date
“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.”
One way to address this problem and a variation on this “sunset clause” is to give the Owner the discretion to terminate the LTSA after the completion of a given scheduled maintenance outage if, by that time, the term has extended beyond the originally envisioned time duration. Depending upon the LTSA’s overall payment structure, this approach may avoid the need for any “true-up” upon such termination as both parties would essentially be “even.” It, in and of itself, acts as a “natural” true-up.

33. Pitfall #7 Limited OEM Obligation for Last-Installed Parts
So let’s say you have reached the end of the term of your LTSA…have you thought about where this will leave you in terms of parts?
Despite the “long term” nature of LTSAs, Owners often make the mistake of not focusing on events under the contract that will occur in the distant future. For example, upon the completion of the last major inspection that, assuming a maintenance-based term, will signal the end of the LTSA term, a number of important issues will arise.

34. 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?
These include: [read slide]

35. Incentives During the Term for the OEM to use “Top Quality” Parts:
OEM responsibility for Unscheduled Maintenance costs
Liquidated Damages
Availability Guarantee
Under most LTSAs, the OEM will have many incentives to ensure that, at least during the term of the contract, the quality of such a blade, is such that it will last as long as possible. For example, some LTSAs require the OEM to bear a certain amount of the costs related to unscheduled maintenance, or, perhaps, to bear a portion, if not all, of the cost of “collateral damage” as a result of the failure of a Program Part. Other LTSAs will require that the OEM to pay liquidated damages related to its failure to live up to an “Outage Guarantee” or a “Reliability Guarantee.” In either case, during the term of the LTSA, the OEM is motivated to install top quality parts to maximize endurance levels, and thereby minimize its own risks.

36. “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.”
In this respect, Owners would be well advised to insist upon a complete “end-of-term” warranty for parts installed in the equipment at the end of the term. Ideally, the OEM would warrant these “last-installed” parts until the next scheduled maintenance event during which such parts would normally be replaced.

37. Pitfall #8 Not Allowing for Early Cancellation of LTSA
So having discussed whether it makes sense to terminate your LTSA at the end of the “sunset” period in the event it drags out longer than the parties would like…
This brings up the question of what do you do when you are only half-way through the Term and decide that an LTSA no longer makes sense?

38. “22. Termination for Convenience
“22. Termination for Convenience. Owner may cancel this Agreement for its convenience at any time upon notification to OEM.”
While the right to terminate “for convenience” would certainly be nice, this is not very common.
The OEM, after all, is not going to want to “walk away” from its “long-term” profits.
After all, from the OEMs standpoint, an Owner’s commitment to a long term service agreement is exactly that: a long term commitment -- and that the agreement cannot be terminated, except by breach of contract. After all, a “deal is a deal.”
So what do you do?
Well, one solution that we have seen…

39. “23. Right to Terminate Without Cause
“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 ….”
…is for the parties to agree to a “liquidated damages” style fee that would be payable in order to allow the Owner to exit the contract. Such a fee would be designed to provide the OEM with at least partial payment of its long-term profits. While not in essence a “true” liquidated damage, such a “fee for early termination” will allow the Owner to “get out” of an economically non-competitive deal (and keep his turbine running) AND, at the same time, it will allow the OEM to keep a portion of its expected long-term profits.

40. “24. Right to Re-Negotiate Pricing
“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.”
Another possible solution would be to include a provision in the LTSA that, upon the occurrence of a certain “trigger,” will guide the renegotiation of prices, or that will allow the OEM the right to “match-and-beat” market prices prior to the vesting of the Owner’s termination right.
Of course, be prepared for a fight. As well as an OEM wanting to “re-open” some “not so favorable” terms for him as well.
And now, the moment you have all been waiting for.

41. Pitfall #9 Failure to Consider State Tax Law Ramifications
9 out of 10 LTSAs will have the OEM having responsibility to perform all Unscheduled Maintenance. Depending on how the LTSA is drafted, one read would require that such part be repaired or replaced under the OEM’s contractual warranty obligations - at its own expense. However, an alternative read of the contract would focus on the fact that an unscheduled outage has occurred, and that the OEM’s primary obligation is to perform the required “unscheduled maintenance.” Depending upon the way that unscheduled maintenance is paid for under the contract, the costs of the OEM’s performing such work could be borne entirely by the Owner.
Which interpretation is the correct one?

42. Real property vs. personal property
Important State Tax Considerations
Taxes of sale of Parts
Taxes on services
Taxes on “use” of Parts
Real property vs. personal property
A single sentence requiring the OEM’s warranty obligations to take precedence over its unscheduled maintenance obligations will ensure that there is no difference of opinion as to just who bears the associates costs and will settle the issue in the Owner’s favor from the very beginning.

43. 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.

44. Pitfall #10 Dangerous Limitation of Liability Clauses
…there are some very valuable pointers you need to be aware of which, if you follow, can avoid several pitfalls often found in these clauses.

45. “46. Limitations of Liability
“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.”
The first pitfall involves the manner in which the OEM’s liability is limited. Although approaches vary, it is not uncommon for the maximum amount of OEM liability to the Owner to fluctuate over the term of the contract. Many LTSAs establish LOLs that directly correlate with the amount of money that the OEM has previously been paid under the LTSA during a given time period (e.g., during the prior one or two years or during a given maintenance interval). Owners must beware of LOL clauses that are structured in this manner.
For instance, if payments to the OEM vary based upon equipment operation, then such a structure can lead to an unreasonably low LOL any time that the operation of the equipment results in inordinately low LTSA payments.
Instead, Owners should insist upon an LOL structure that sets a single, aggregate LOL amount that is applicable for the full term of the contract, and that is not associated with fluctuating OEM payments or time periods shorter than the full term.

46. Contractor
3rd Party
Owner

47. “46. Limitations of Liability
“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.”
The first pitfall involves the manner in which the OEM’s liability is limited. Although approaches vary, it is not uncommon for the maximum amount of OEM liability to the Owner to fluctuate over the term of the contract. Many LTSAs establish LOLs that directly correlate with the amount of money that the OEM has previously been paid under the LTSA during a given time period (e.g., during the prior one or two years or during a given maintenance interval). Owners must beware of LOL clauses that are structured in this manner.
For instance, if payments to the OEM vary based upon equipment operation, then such a structure can lead to an unreasonably low LOL any time that the operation of the equipment results in inordinately low LTSA payments.
Instead, Owners should insist upon an LOL structure that sets a single, aggregate LOL amount that is applicable for the full term of the contract, and that is not associated with fluctuating OEM payments or time periods shorter than the full term.

48. “47. Carve-Outs from to LOL
“47. Carve-Outs from to LOL. OEM’s liability for third party claims shall not be subject to the LOL in 46 above.”
The bottom line here is that the OEM’s indemnification liability for third party claims ­should not be capped at all under the LOL.

49. LTSAs: Top 10 Contractual Pitfalls And How To Avoid Them:
Clearly Defining “Scheduled Maintenance”
Clearly defining “Extra Work” concepts and cost allocation
Appropriately Allocating “Prolonged” Start-Up Risks
Protecting Owner Interests in the Absence of Performance Guarantees
Preventing “Illiquidity” of Parts
So to re-cap: Today we have talked about the top 10 contractual pitfalls that an Owner should be aware of when thinking about entering into an LTSA. As we are sure you are aware, there are a lot more than 10 out there and we have only begun to scratch the surface. I am sure that you can probably think of another 10 right off the top of your head.

50. LTSAs: Top 10 Contractual Pitfalls And How To Avoid Them:
Negotiating an Extended End-of-Term Parts Life Warranty
Avoiding the “Absurdly Long” Long Term Service Agreement
Allowing for Early Cancellation of LTSA
Considering State Tax Law Ramifications
Structuring Appropriate Limitations of Liability and Exceptions