Lenders to the South Bay Expressway have been drawn into the litigation between the project company and its contractor, as debtholders move closer to taking control of the road. South Bay, or SBX, formerly known as SR-125, was the first greenfield road PPP to close in the US, and the first private road project to use a TIFIA loan.

The outcome of the discussions about the project's restructuring will show how robust private concessions can be in the face of revenue weakness. It is also likely to be the first test of the springing lien that TIFIA loans hold over projects – that TIFIA is subordinate in terms of cashflow but would rank pari passu in the event of default. SBX is subject to $140 million in TIFIA debt, although commercial lenders are taking the lead in the litigation.

BBVA is administrative agent on $340 million in senior bank debt, and was one of two lead arrangers on the project's financing in May 2003 (the other was Depfa). The project experienced a prolonged and difficult construction, and the principal amount of the senior debt was reduced to the current balance from $400 million in early 2008. The sponsor, Macquarie Infrastructure Group, agreed to contribute additional equity to make up the difference.

Macquarie is in the process of splitting MIG into two new entities, Intoll and Atlas Roads Group, and the prospectus for Atlas, which would own the SBX interest, notes that the value of the SBX holding has been written down to zero. This write-down does not, for now, prevent Macquarie from having a continued role in the project, and it could realise recoveries during the restructuring.

But the developments may explain the lenders' decision to initiate litigation against the engineering, procurement and construction contractor on the road. The contractor, Otay River Constructors (ORC), is a joint venture of Washington Group and Fluor, and it has been engaged in arbitration and litigation with the project company since 2005, and filed a suit against the project company in San Diego in July 2006.

The contractor dispute is complex because the toll road and an associated gap-connector project were procured under separate design-build agreements, with different arbitration regimes. The disparity, as well as difficulties with other project contracts, resulted from Macquarie taking over the project at a late stage in its development, which meant that not all contracts were struck on terms that accorded to project finance bank market norms.

At a later stage in the litigation, in 2008, ORC asserted that since the project was a public works project, even though it was procured under a PPP concession, the project company had to have a California contractor's licence to build the road. The contractor made the same assertion in a suit it launched against the California Department of Transportation, the grantor for the project. The assertion has so far been rejected in California's courts, where a number of intertwined cases covering the projects, legal fees and other subcontracts have rumbled on.

But the suit from BBVA, which was filed by its law firm, White & Case, in late August, says that these attempts to reject the design-build contracts amount to a breach of consent agreements that ORC signed as part of the financing, during which the agreements were assigned to the lenders. The suit adds that the consent agreements amount to a promise not to "rescind, cancel, terminate, or suspend or amend or modify" the design-build arrangements, and that these are a standard part of project finance documentation.

The response, from OTC's legal counsel, Jones Day, centres on the fact that the lenders have not yet suffered any harm from the moves to reject the contract. The banks, according to sources familiar with their deliberations, took the step extremely reluctantly, and the suit was filed almost a year after a similar action from the project company against the contractor.

According to Glenn Kurtz, the partner at White & Case handling the litigation, "the case is about the ability of lenders to enforce agreements that are central to project financings, and it's important that courts reject parties' attempts to reject these agreements. There's a wider significance."

The move also makes sense if BBVA and the United States Department of Transportation, which runs TIFIA, could shortly become the owners of the road. South Bay runs for 13.9km along the east of Chula Vista and San Diego, taking in both suburban commuter traffic and goods traffic on the way to the border with Mexico. Current economic conditions have reduced both types of traffic, and the road, whose January 2008 opening was delayed, has performed below expectations. The project company notes that the road passes through the last patch of land available in the region for additional development. But in the wake of the collapse in the US property market, which hit California hard, development activity has slowed to a crawl. Revenue on the road is thought to be roughly a third of forecasts.

The most recent filing in the case, from Jones Day in December, attempted to have the case dismissed, on the grounds that racking up legal fees to file a suit to counter a legal assertion does not count as evidence of harm. The filing even ventures to suggest that lenders might come out whole, a possible allusion to a refinancing proposal that is rumoured to be in front of the lenders. It says that even if ORC won its case and this damages lenders, "BBVA's loan may be repaid fully at that time, rendering useless its collateral". An earlier White & Case filing for the plaintiff, however, says that precedents allow it to seek a judgement regardless of current harm.

The case, say sources close to the project company, is an important test of the validity of project agreements, one with some application to project finance elsewhere in the US. Certainly the ability of a group of lenders to hold a contractor to its agreement is an important foundation of risk transfer in project finance. The SBX dispute, however, centres on a corner of California contracting law, and an interpretation that has not garnered any acceptance.

The best indication of what is at stake comes in a White & Case motion from December. The motion notes that the documentation for the deal says that the consent agreements, "are enforceable 'except as the same may be limited by bankruptcy, insolvency or other laws relating to or affecting the enforcement of creditors rights generally and by general principles of equity.'"

If South Bay does get restructured in bankruptcy, the lenders' job in enforcing these agreements would be much harder.