Project Finance.Qxd

Project finance haps a more realistic grounding for the Rules for negotiating field, and the development of independ- ent power projects in the US after the 1978-1979 oil crisis gave rise to the project finance deals model for many of our modern projects. Recent years have seen this model used in an ever-broadening range of countries. Although projects lawyers are Phillip Fletcher explains the art of negotiating an international project clustered in London, New York and financing to achieve consensus in the absence of set rules Hong Kong, as the application of project finance has spread, they are now found in almost every city where com- plex transactions are documented. Twenty years ago, debate raged over whether non-recourse (project) lending violated the regulations that required commercial banks to limit themselves to “prudent banking practices”. More recently, focus has been placed on the extent to which capital reserve requirements should be increased on project loans in accordance with the Basel II accord. The decades have shown that restructurings are common (perhaps due to the pervasive covenants imposed on borrowers), but losses have been relative- ly rare. Nonetheless, the idea that recourse on a loan should be limited to a special purpose borrower and its assets remains a focus of attention. This has not, however, stemmed the flow of project finance deals. The world’s rising demand for energy and natural resources, driven in large part by the remarkable growth in the Chinese and Indian economies, has led to a rapid growth of investment in resource extrac- tion projects. With prices at record levels, international oil companies are exploring for energy in remote parts of roject finance is difficult to define basic rules must flex to meet the facts and West Africa, the Caspian and the but easy to recognize; it generally issues in question. In the absence of rigid Middle East, and the resulting projects P involves lending significant market standards and agreed form docu- often entail billions of dollars of capital amounts of money to a thinly capitalized ments, the project finance lawyer must costs. Many of the host countries have company whose primary assets consist of patiently assess the economic, technical, never seen financing, or even commer- contracts and licens- political and legal cial, transactions on this scale. At the es, but that is where risks presented by same time, a number of more developed the simplicity ends. each project and countries have used these techniques to Notwithstanding the draw on experi- broaden the participation of the private efforts of various The most common dispute the ence to help the sector in traditional public sector activi- governments to projects lawyer encounters is parties reach a ties, ranging from utilities to roads, standardize private workable consen- hospitals, schools and prisons. Although finance initiative over the terms and enforceability sus in face of the underlying commercial law is settled (PFI) and similar often unique in these countries, public/private part- documentation, the of long-term so-called take or challenges. nerships have often required broad field defies the pay contracts The discipline reforms of regulatory regimes to accom- application of fixed is old. Some date modate them. Thus, as project finance rules. The range of the onset of the has moved into new areas, the legal assets financed, from practice to the issues have become more challenging. underground mines financing of the to overhead cables, and the breadth of Panama Canal over a century ago. The The joy of the covenant jurisdictions covered, from Canada to big mining deals in Africa and Latin In the most basic terms, project finance Mozambique, mean that even the most America of the 1960s and 1970s are per- is a form of secured lending. Much of the www.iflr.com IFLR/November 2005 1 Project finance legal expertise is drawn from the disci- ments to political risk insurance from sions turn on the facts of the case, the pline of banking. One who sees the official credit agencies and a variety of terms of the underlying agreements and beauty of the perfect covenant, the joy of Shari’a compliant instruments issued by the environment in which the dispute is an all-encompassing event of default or Islamic institutions, they must be able to heard. the elegance of a multi-tiered intercredi- document the differing requirements of a tor agreement has the capacity to excel in wide range of markets. In fact, their Risk assessment the field. But the inclination to do so expertise must extend far beyond finance The role of the project finance lawyer is comes from never having outgrown the papers: the best among them are able to to seek to bring some advance certainty wish to play with big toys. Like asset act from the inception of a project as it to this process by identifying the funda- finance lawyers, the projects lawyer needs progresses from negotiating its construc- mental risks and getting the parties to to know how to take security, fixed or tion contracts to the day it issues a agree who assumes them long before they floating, over every asset imaginable, but prospectus for a public issue of securities. arise. They focus the parties’ attention on they must also understand how the The more modest will confess that they the worst case scenarios, thereby making underlying facility operates and its ability are merely adept at deploying the expert- them consider circumstances none of to generate revenues for periods encom- ise of their firm across this broad range them wishes ever to encounter. There is passing decades. of requirements. rarely any debate about the effect of an Legal analysis is but one element of The most common dispute the proj- act of God (most of which can be the project finance due diligence effort. ects lawyer encounters is over the terms insured), but when the discussion turns Technical advisers assess the physical and enforceability of long-term so-called to who takes the risk of an act of govern- plant, market take or pay con- ment, such as the imposition of a new advisers predict the tracts. These tax or an import restriction, any of which availability and contracts, in all might change the fundamental econom- cost of inputs and their permuta- ics of the deal, the debate can be heated. the value of the Having spent years as insolvency tions, underpin No party can easily assume a risk that is future revenue practitioners, projects lawyers most big projects. beyond its control, and governments streams, and model The sale of rarely reassure parties that such risks will auditors assess the are today working on floats, power, of oil and not arise, as they generally do not wish to integrity of the trade sales and other exits from gas, natural fetter the discretion of their successors. financial models. resources, Whether there are price re-openers to The lawyer works these now successful investments telecommunica- address unanticipated shifts in market with these other tions capacity conditions can also be controversial. experts to identify and a range of These issues became heated during the risks and to gener- other products is crisis that hit many developing countries ate an integrated due diligence report - generally framed in a contract in which in the late 1990s. Currency devaluation often stated to be limited to legal issues, the purchaser agrees to take a minimum caused the cost of debt denominated in but out of necessity based heavily on level of output at a price based on some dollars, and the price of goods and serv- contributions from a variety of experts. form of set formula for a specified peri- ices acquired in dollars, to sky-rocket in Out of this process the parties are asked od. The project company is thus local terms. Electric utility companies, to assess the “bankability” of a potential contractually insulated, at least to some paying for power and fuel in dollars, risk or the project as a whole. degree, from the one thing it can least simply could not pass on the cost to That no project is the same should be control: long term market conditions. local consumers whose incomes were set apparent. Variables such as the robust- Minimum volume commitments can in local currency. Every defence imagi- ness of the underlying economics, often be particularly burdensome on the buyer nable emerged, along with notable tested by reference to anticipated debt when they are matched by a fixed or disasters, such as the failure of Enron’s service coverage ratios, the degree of floor price on those volumes. If you try Dabhol project in India, and more rea- complexity and reliability of the asset’s to sell 8¢ output in what has become a soned restructuring of power projects in technology and the stability and trans- 2¢ market, before long the purchaser Pakistan and Indonesia. Each of these parency of the host country’s political will try to find a way out of the deal. had capital costs well in excess of $1 bil- and legal environment, determine how The claim could be disingenuous: “we lion and thus attracted considerable accommodating investors are likely to be didn’t understand what the deal was attention. In the successful restructur- in relation to legal and other risks. about”. It could be mysterious: “the con- ings, lenders rescheduled debt, sponsors tract was entered into only because you accepted lower returns and the tariff was Take or pay bribed our government”. It might even consequently reduced, but perhaps more What are the legal issues a projects appear reasonable: “we can’t take the importantly (and quite unintentionally), lawyer deals with in making these assess- output because a hurricane blew away the process took so long that the local ments? Few legal disciplines are not our transmission grid”.

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