Legal Aspects of Project Finance
-----Catherine Chao

In general practice, project finance is widely in use of the following projects:

1) natural resource projects (eg. oil, gas and minerals); 2) infrastructure projects (eg. roads, bridges, tunnels and dams); 3) power projects (eg. power stations and electricity projects); 4) refineries and pipeline projects; 5) IT projects (eg. Telecommunication and satellites); and 6) other projects that require long-term financings.

The three major players involved are:

1) Sponsors, the proponents of a project who win the licence or concession to proceed with the project, often they will be acting through a subsidiary which is usually a consortium whose members represent interests in the various stages of the project. There will be a joint venture agreement or a shareholders' agreement between the members. Under such a structure, the main purpose is to make the subsidiary isolated and to avoid unlimited liabilities of partnership.

2) Project vehicle, also known as project company, the central vehicle of proceeding the project. It is a dedicated single-purpose separate corporate entity with the sponsors as its shareholders, or joint venture between the sponsors, or a leading sponsor operating for joint venture. It depends on the relevant jurisdiction of the project as to which form to take.

3) Bank(s), the financier who support the project with the proceeding loan, usually in the form of a revolving facility.

Since such kinds of projects might come across huge potential risks, for example physical risks like catastrophes or other incidents destroying or damaging the whole project; technology risks; resource risks; price risks like cost overruns and currency risks etc. As the major financier, the bank(s) usually might become the ultimate sufferer after the project company, the government, the sponsors and others in the event that the project goes wrong. Following is a brief discussion of those principle financing risk assessments that the bank has to make before committing to a project, and what legal documentation can do to minimise the risks so as to protect the bank.

The principle financing risk assessments that the bank has to make.

From the bank's perspective, the risks might include:

1) Non-recourse nature.

The project usually is done on either a non-recourse or a limited recourse basis against the government (i.e. the licensing authority), sponsors, project company and others. Therefore in the banks' consideration, if the project is owned by a one-single purpose company, the banks have no recourse to the project sponsors because of the veil of incorporation (any guarantees by the sponsors will of course override this, but it is still very limited); if the project is owned directly by the project sponsors, the recourse to them can be limited by contract, and the bank can only look to the security, because of the jurisdiction difficulties, which are often technically unsatisfactory.

The methods of achieving non-recourse financing (under English common law concept):

a. by limiting interest payments and repayments of principal to revenues and assets. Either in contract between the sponsor and the company cover the issue, over which the security can be taken, or alternatively, the bank may ask sponsor enter into a three-party contract. Generally, when the project starts, not much profits can be achieved. So to make it the company's liability to make ongoing repayment subject to the cash resource of the project company;

b. by limiting the lenders' rights to the security alone, without a personal covenant to pay, basically for the borrower not to have repayment, simply tight in the limits of the security.

2) Changes of the licence.

Make sure that the licence cannot be altered or changed. Firstly, in the loan agreement documents, insert such articles as to not to accept any changes of licence. Secondly or alternatively, the bank makes itself as a party of the contractual documents with the government.

3) The failure of the project.

a. termination of the licence through breach or other reasons
b. physical failure
c. technology failure
d. force majeure
e. borrower's default

4) Political risks/change of law risks.

This is an act by sovereign power. The bank needs to assess the stability of the host country.

5) Other problems leading to cash flow and revenue difficulties.

a. cost overrun;
b. exchange rate risks, i.e. the issue of foreign currency investment/cost v. local currency revenue. Usually the bank enters into a hedging or a series of hedging contracts to minimise the currency risks;
c. delay of project and/or temporary suspension;
d. sales difficulties.

6) Sponsor defaults;

Sometimes, the sponsors default in supporting the project themselves in terms of providing sponsor finance continuously.

7) Assessing the allocation of risks in the project documentation, make sure that there are no "holes".

8) Environmental risks;

Environmental issues are material to the project, they are either strict (eg. oil leakage etc., under which circumstance, the owner of the land/premises is liable in most of the jurisdictions) or related to default.

It is important for bank to look at this issue, for:

a. The environmental risks affect the project company, and then affect the bank. They are indirect risks;
b. Sometimes, it might be direct, simply because the lending connection. More likely, in consequence of the holding security over project assets, when the bank enforces such security or exercise step-in rights, it will face the direct risk.

9) Other legal issues.

Other legal issues include insolvency, security enforcement, conflict of law, governing law and disputes/jurisdiction issues etc.

The financing structure and documentation to protect the bank:

1) Co-ordination of the different elements, to find out whether it is a unified financing for the whole project or a separate financing for different elements of the project (eg. In a bridge or motorway project, one needs to find out what the end of the bridge/motorway is. It is quite important to have these all connected together).

2) Co-ordination of finance with credits, grants and aids (eg. In an oil project, for pipes used in the projects, they can get governmental subsidies. The bank needs to consider how it is going to be included in the documents).

3) Some projects in developing countries usually involve international institutions like World Bank, IMF, sometimes the local bank loan may be added into the international institutions'.

4) Linkage to sponsors' finance

5) Syndicated lending as the established model for private sector bank lending, with certain modifications to voting rights.

6) To make sure to incorporate the following articles in the loan agreement provisions, in addition to the usual provisions in a typical syndicated facility:

- The initial condition precedents

- The usual financing condition precedents used in syndicated facility;
- Project condition precedents; eg. Providing copies of feasibility and environmental impact studies (also addressed to the lenders for reliance purposes) and copies of all project documentation; insurances; and tripartite agreements etc. Also the obtaining of all necessary permits for the project. The syndicated banks stand or fall together, they have joint liabilities, they are not like normal syndication practice where the bank bears liabilities individually.

- Drawdown linked to expenditure requirements

- Condition precedents to each withdrawing and to be repeated

- Interest is usually floating, and usually rolled-up prior to completion, i.e. add to principle, because the project company at that stage has no revenues.

- Repayment of the finance

- Linked into project revenues and compensation and insurance payments

- Covenants and undertakings

- Various financial/revenue cover ratios (forecasting on a running basis, eg. every six months, main cover ratio: financial test, cash flow tests i.e. conducting forward & backward looking by specialists).
- To comply with the project documentation and to enforce the same
- Not to agree amendments to or waivers of the project documentation, especially project plan.
- Controls on capital expenditure
- Controls on other debt
- Not to terminate or abandon the project
- Insurance provisions (see below)
- Environmental liability issues; obtaining consents, to provide relevant studies and reports, no outstanding breaches or liabilities, to maintain an adequate environmental monitoring scheme and to remedy any damage
- Where practicable, to obtain insurance cover
- Indemnification to the lenders

- Events of default

- Loss of the licence
- Failure or termination of the project or a major project contract (non-completion by a long-stop date i.e. abandonment)
- Breach of a cover ratio (lower)
- Uncovered force majeure events
- Default by the sponsors
- Changes in the sponsors or in their shareholdings in the project vehicle
- Cross-default relating to the sponsors and major contract parties
- Loss of insurance cover

7) Controlling the cash flows;

- The establishment of bank accounts for the vehicle

- Location:
- with a bank in an international financial centre (such as London, New York)
- Also, to have local accounts for local currency expenditure and receipts

- Examples of the types of account
- the disbursement account (into which are paid loan drawdowns and sponsors' finance, from which are paid project expenditure)
- the revenue proceeds account (into which are paid all operating revenues generated by the project, from which are paid amounts to be paid into the debt service account, from which might be paid amounts to be paid into the disbursements account for future expenses); normal external (to insulate them from local rationing or diversion by the local central bank)
- the capital proceeds account (into which are paid compensation payments and insurance claim proceeds, from which would be paid into the disbursement account and the debt service account)
- the debt service account (into which would be paid amounts from the revenue proceeds account and the capital proceeds account, from which are paid amounts to pay the lenders their interest and principal)

- Controls by the lenders over the operation of the accounts

- Allowing access for authorised expenditure

- Security over the accounts in favour of the lenders

- Fixed or floating charges

8) Step-in rights on the Borrower's default/event of default;

- the banker itself or a receiver (where there is a floating charge) to step-in and replace the borrower and take over the project under the relevant license or contract

- as an accompaniment to the lenders' security

- usually in the form of a tri-partite agreement between the lenders, the borrower and the relevant third party over the licence, the various project contracts and the insurances.

- Sometimes the third party may be required to give warranties to the lenders, such as: acknowledging a responsibility/duty of care to the lenders; undertaking duty to perform the contract; provisions as to obtaining and maintaining insurances and cover of the lenders.

9) The insurances;

- the categories of insurance cover in a project:

- physical damage or loss of the project assets cover
- third party liability cover
- environmental liability cover
- delay in start-up and business interruption cover
- political risk

- who takes out the cover (different periods):

- risks during construction are usually covered under the contractor's policies;
- post practical completion cover will usually be arranged by the sponsors or the project vehicle.

- who should be covered?

- the sponsors and the project vehicle
- the licensing authority
- the contractors
- the lenders

- the insurers usually shall be of international standards, often through the Lloyds' market, as approved by the lenders. However, sometimes problem arises where national law or the license requires the involvement of local insurers.

- the usual insurance covenants in a loan agreement

- to effect/procure the specified insurances to the specified limits of cover
- that the insurances will be effected through approved brokers and underwriters
- to obtain non-vitiation clauses in favour of the lenders (if available)
- to obtain brokers' undertakings in favour of the lenders by which the brokers agree to notify renewals and failures to renew or pay premiums, arrange loss payable clauses as agreed, effect notices of assignment (as security) and endorsements of the lenders' interest and hold the policies and payments to the lenders' order.

10) Security.

To take security is said to be primarily defensive, i.e. it is a shield not a sword, because normal enforcement realisation may be unrealistic. Assets are often non-marketable, and one might face political interference etc.

- centralising the security for the benefit of all the lenders/funders and other facility providers (usually through a trustee mechanism, it can only be recognised in certain jurisdictions)
- the assets (ideally the security should cover all the project assets, but this is not usually possible outside the common law group).
- the licence
- contract rights (construction contracts, supply contracts, project sale contract)
- insurances
- the bank accounts
- the business, goodwill, capital etc. of the vehicle
- immovable assets
- tangible movable assets
- project company's claim against third parties

General problems of security:

- the floating charge is not available in certain jurisdiction;
- enforcement is limited to judicial public sale, not private sale;
- there is no right to possessory management (through a floating charge receiver), the only way is sale;
- burdensome formalities, especially for debts
- prior preferential creditors;
- sale to aliens restrictions;
- cancellation of the concession/license etc.;
- no sale for foreign currency and exchange control;
- non-possessory security over tangible movables is invalid or cumbersome;
- environmental liabilities on enforcement.