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 coun- tries. 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 proj- ect 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 require- ments 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”. It might also be economies had time to recover and the relevant. Projects lawyers use all of the on the basis of defences at law: “we are tariffs again became affordable. In the skills learned in law school, bar (one broke, we can’t pay and the court says failed Dabhol project, amidst allegations hopes) criminal procedure; the law of you can’t make us”. Or in equity: “it’s of abuse of the original negotiating contracts, property, trust, torts and equi- unfair to make us pay this much over process, construction halted and the ty feature regularly in their practice. As the market”. There are court decisions in asset was left to rust, with only the liti- the financing instruments range from many jurisdictions addressing a broad gating attorneys being the winners. bank loans and capital markets instru- range of such circumstances. The deci- These crises hit not only developing

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economies. In late 2002, the collapse of putes be heard? What law will the forum shares. large power traders such as TXU Europe apply and will the result differ as a A notable debate arose in the context and Enron, among others, left much of result? Will judgments or awards be of projects being developed in a Middle the UK power generation sector insol- enforced in the home jurisdiction of the Eastern jurisdiction that lacks both a vent. Banks assumed de facto ownership assets, the borrower or the other project code governing the registration of secu- over much of the industry. A few years parties? A decision focused merely on a rity and even a basic insolvency law. later (as power prices have recovered) preference for a familiar law or forum Early projects sought creative means to the defaulted loans are trading back at could miss the changes in legal result allow lenders some form of security over par, and many banks (or the hedge that might turn hard assets. funds they sold to) have recovered addi- on these choices. Solutions extend- tional, unanticipated equity value. The importance ed to effecting an Having spent years as insolvency practi- of the choice of offshore condi- tioners, projects lawyers are today law or forum Who would want to foreclose on tional sale of the working on floats, trade sales and other might be even a satellite orbiting the earth assets. When the exits from these now successful invest- more acute when structure was put ments. the country in 35,000 kilometres above the through the dis- which the project closure of a public London or New York? is located either equator? capital markets A second area of regular focus is in has no tradition of issuance, the cor- respect of the selection of governing law. reported case law responding risk Sometimes the issue is limited to the or where domestic factor caused such choice of the law governing the loan law, is, say, based focus on the agreement, generally as between English on Shari’a principles that prohibit such uncertainty of the regime that the or New York law. The preference is per- fundamental elements of the transaction underwriters concluded it best to do haps less substantive than meets the eye as the charging of interest on loans. In without that form of collateral security. as much of the case law in those jurisdic- some cases, a choice of foreign law and a Without legislative change (which might tions on the enforceability of customary selection of a neutral forum might be be forthcoming), subsequent deals have finance agreements comes to similar con- helpful even if enforcing an offshore also done without. Perhaps this is clusions. The debate can nonetheless be judgment back in the host country is because the underlying economics of the heated in the “battle of the preferred likely to be challenging. In other cases, projects are sufficiently robust to allow forms”. The corresponding choice of it might make better sense to structure compromise on these issues. Security, forum for dispute resolution is, however, the transaction to conform to Shari’a however, remains a vital element of perhaps more interesting, as a variety of principles than hope for enforcement of weaker transactions in other countries. parties have a preference to litigate in a non-Islamic transaction. The financing of satellite projects either London or New York and not the presents similar challenges. Who would other. Creating security in a barren want to foreclose on a satellite orbiting But the question can have real sub- land the earth 35,000 kilometers above the stance as well. Let us take the case of a A third area of regular challenge is struc- equator? More to the point, because natural gas products project in a West turing security packages, often across space is beyond the jurisdiction of indi- African country. The off-take contracts, jurisdictions and over diverse assets. A vidual states, where would one register in the form of a forward purchase of lender’s collateral package serves two pur- the interest? Treaties have addressed how future production, were between the poses: it allows the lender to deprive the to register security over aircraft and West African producer and an offshore borrower of the pledged assets when the ships, which by their nature can operate special purpose company incorporated loan is in default and it assures the lender in numerous jurisdictions. But no inter- in Bermuda. The Bermuda company that no other creditor is able to take national convention exists (though one borrowed loans to finance the purchase those assets in preference to it. The avail- is being formulated by Unidroit, the of the products from the producer; it ability of such packages have generally Rome-based International Institute for then on-sold those products to pur- given lenders the confidence to extend the Unification of Private Law) for the chasers worldwide and used the proceeds long-term, (relatively) low-cost loans. taking of security over objects in space. of those on-sales to service the loans. Where an asset is located in a country This has not prevented satellites from The financing documents were governed with no filing or registration code, or being project financed. While the single by New York law and the project’s bank where the enforceability of contractual most valuable item might be beyond the accounts were charged to the lenders step-in rights granted to lenders is uncer- physical grasp of secured creditors, care- under English law in London. The gov- tain, the challenges are considerable. In ful structuring has allowed creditors erning law of the off-take contract could addition, some countries charge high fees constructively to repossess satellites by reasonably have been chosen by refer- for the registration of security, but often taking assignments of operating agree- ence to any of these jurisdictions. The without providing certainty that such ments and licenses (where permissible), choice could have affected fundamental security can be enforced. In such cases, revenue-generating customer contracts issues, including the circumstances in the lenders are often asked to do without and in-orbit insurance. which title to the future production the traditional security package and are effectively passed from seller to buyer asked to rely solely on pledges of offshore Ecological considerations and the enforceability of liquidated bank accounts, assignment of export con- Back on earth, an area of increasing focus damages for breach. Where should dis- tracts and, in some cases, security over is environmental and social planning. www.iflr.com IFLR/November 2005 3 Project finance

Local environmental legislation might third party developer. Had the intercredi- agencies in Asia, Europe and North simply not exist in some jurisdictions, tor relationships and security package America, in coordination with multilater- but projects financed by national or addressed all of this? No. But were the al institutions, such as the World Bank, multinational credit institutions often rules at least enough to define the proce- commercial bank lenders in London, have to comply with World Bank or sim- dures by which the parties would have to Tokyo or New York, and perhaps region- ilar standards. These require the reach settlement? Yes. Had any party not al finance institutions based in (say) comprehensive mitigation of environ- shown maturity and judgment, all would Dubai or Johannesburg, is dependent on mental emissions and management of the have been lost. the project finance lawyer’s ability to help project’s impact on The Gulf wars the parties reach a workable consensus. local populations. gave rise to similar Recognizing who has negotiating A wide variety of issues. Faced with leverage in this context is perhaps more non-governmental a deteriorating art than science. Broadly stated, as glob- organizations environment in al financial liquidity has grown and as (NGOs) have pres- Recognizing who has the region, lenders official credit agencies have placed a sured leading negotiating leverage in this were reviewing high priority on encouraging global commercial banks carefully material diversity of energy sources, sponsors and into accepting sim- context is perhaps more art than adverse change even host governments have gained the ilar standards. The science conditions in both upper hand. The process adopted by adoption of the so- underwriting and governments of competitively tendering called Equator credit agreements. the opportunity to develop a project, Principles by these In some cases, the and of sponsors in turn tendering the banks has now condition was opportunity to finance it, has allowed largely aligned their requirements with clear, in others not, however, the region the sponsor market to gain enhanced those of the World Bank. As a result, big as a whole responded in a considered leverage over financial institutions. projects generally have to meet standards manner, deferring closing dates where However, projects must still meet the that far exceed those that would be appropriate, accommodating price flex benchmark of bankability and the proj- required by domestic law in the host when needed and, more structurally, ects lawyer is often called upon to help country. Lenders have in effect assumed host governments agreed to absorb a cer- form a view as to whether they do. the role of the absent global environmen- tain degree of the risk associated with Allowing negotiating leverage to flow as tal regulator. terrorism or war. As a result, few proj- the market demands, but preserving the ects were disrupted and since then the essence of the credit, is the art of the Troubled waters market has flourished. deal. A host of other challenges arise when projects encounter difficulties. For exam- More than a lawyer Phillip Fletcher is a partner at Milbank ple, in a project in Florida, a change of Against this mosaic of issues, the role of Tweed Hadley & McCloy LLP in London governor led to an investigation of the the project finance lawyer is not limited and is a member of IFLR’s editorial board legitimacy of the project’s environmental to answering specific legal questions, but permit. Unfortunately, this occurred part extends also to organizing the process way through construction. A reasonable and setting priorities for what must be decision would have been to suspend achieved. Negotiations take place among funding under the $650 million debt numerous parties. Each has an interest in facility. However, this would have caused the deal, but each interest is limited by the virtual write-off of the outstanding the scope of the role and the anticipated disbursements; there is little value in a benefits to be derived. Ask too much of half completed plant. The decision to any party, and they will be deterred from continue funding and complete the proj- participating; ask too little and the over- ect while seeking to negotiate a all viability and security of the project settlement with the environmental might be brought into question. A con- authorities required, at a minimum, cession made to one party, for example nerve. Two tranches of senior lenders going without the requirement for the (commercial banks and insurance compa- provision of a completion guarantee, nies) and a syndicate of subordinated might simply impose burdens on anoth- lenders had to reach that decision inde- er. Such a concession could, for example, pendently, and the construction necessitate the provision by the contrac- contractor had to agree to complete the tor of enhanced performance warranties, project without increasing its price or the agreement of the off-taker to despite incurring cost from delays and accept delays in the development sched- the uncertain circumstances. Even more ule or an increased tariff if construction remarkably, the original sponsor (an oth- problems emerge. Trade-offs of this sort erwise well known and successful must be negotiated across legal traditions company) had to recognize that it was and even languages. The success of the now unwelcome in Florida and agree to largest projects, where the sources of debt sell (at a loss) its project to an untainted finance might encompass export credit

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