University Of East Anglia

Norwich Law School

LAW- M608

THE LAW AND PRACTICE OF

INTERNATIONAL PROJECT FINANCE

PG COURSEWORK 2009-2010

STUDENT REGISTRATION NUMBER [4230531]

Word count 3964

Table of Contents

1. Introduction

2. Structure phase

2.1. Joint venture Agreement

2.2. Credit Agreement

2.3. BOT Agreement

2.4. Construction Agreement

2.5. Off-Take Agreement

3. Risk Identification

3.1. The Risk of non-completion or delay

3.2. Market Risk

3.2.1. The Output Price Risk

3.2.2. The Input Supply Risk

3.2.3. Interest Rate Risk

3.2.4. The Exchange Rate Risk

3.3. Political Risk

3.4. Insolvency Risk

4. Security Interest

4.1. Mortgage Security

4.2. Assignment by way of security

4.3. Security on Special Bank Account

4.4. Novation

5. The position of the Ruritania government as creditor in the event of insolvency

5.1. Intercreditor agreement

6. Conclusion

8. Bibliography

9. Appendix

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1. Introduction

It is generally agreed that Project Finance -international or otherwise- is a well-

organised form of financing that is tailored to meet the requirements of relatively

large projects. The nature of the typical project finance transactions are complex, and

often involve large capital public sector projects such as power plants, infrastructure

transports, mines, etc.

Historically, project finance has experienced a period of accelerated growth in the last

decades (1980s and 1990s) as a result of the increased demand for financing

infrastructure projects, namely in developing countries as well as emerging markets.1

At present, many of countries are either reluctant or incapable of funding large

infrastructure projects for many reasons. Their tendency to acquire nonrecourse debts2

instead of conventional debts has helped in constituting and promoting the project

finance techniques.

In this field, the term 'project finance' can be defined as a debt financing method in

which the debtor relies fundamentally upon the expected revenues produced by a

single project.3 The assets of such project are almost certain to serve as collaterals.

The borrower is usually a Special Purpose Vehicle4 (SPV) which has formed by the

sponsors of the project, in order to operate and promote the project.

The aim of this essay is to advise the government of Ruritania5 (R) in respect of its

intent to take a part in project finance transaction for the purpose of construction a

hydroelectric power station on the River Hydra in Ruritania. In doing so, the Ruritania

government has formed a project company (P) with a selected instruction company

(C), and entered into take off agreement with neighbouring state Sealandier (S) under

which S will purchase the electricity generated by the power station. Also the project 1John D. Finnerty, Project financing: asset-based financial engineering (2nd end, Wiley, New jersey 2007) xv 2 Nonrecourse debt is a secured loan often by a collateral, under which the debtor is not personally liable. In the event of default, the loaner has the right to recourse only to the collateral or the estimated cash flow. 3 Catherine Pedamon, ‘How is Convergence Best Achieved in International Project Finance’ (2000-2001) 24 Fordham Int'l L.J. 1272,12734 Often a limited company formed in order to fulfil some specific or temporary objectives, as well as isolating the assets and liabilities of the sponsors of the company. 5 An imaginary kingdom in central Europe which is often used in academe to refer to a hypothetical country.

3

financing bank (B)has been identified. This advise will address three key areas. First,

the major risks for the parties who engaged in this project, and probable contracts that

will be agreed upon between them. Second, the variety of securities which are high

likely to be sought by B as a main creditor of the project. Third, in the event of

insolvency what the probable position of R as subordinate creditor.6

2. Structure phase

Typically, the structure of project finance is complicated. It is grounded on the

assessment and allocating the risks as well as rewards among the participants (project

sponsors, off take purchasers, contractors, operators and suppliers) of the project.

Hence, a considerable number of the contracts, which are included in the project

finance structure, aim in essence at achieving the deferring objectives of these parties

often on the reconciling basis.7 In the interest of brevity, this essay will merely

mention the prime agreements that R is going to engage in either as a host

government, as a sponsor or as a creditor of the project company (see figure 1).8

2.1. Joint venture Agreement

As R has formed P in association with C to build and operate the hydroelectric power

station, these sponsors of the project company generally take a part in a joint ventures

agreement under which each of them is liable to profits, losses, and operations

according to its joint amount.9 Unlike partnership agreement, the joint venturers

cooperate solely for a single transaction. However, joint venture agreement is not

merely a form of sharing risks and rewards, but also codifying the rights, duties,

management and voting between the sponsors of the project as shareholders.10

Adopting the joint venture agreement gives parties the advantage of financing the

construction of the project by a nonrecourse loans which are given by B to the project

company under credit agreement.

2.2. Credit Agreement

6 Michael P. Malloy ‘International Project Finance: Risk Analysis and Regulatory Concerns’ (2004-2005) 18 Transnat'l Law. 89 7 Graham D. Vinter, Project finance: a legal guide (3rd end, Sweet and Maxwell, UK 2007) p 38 some of these agreements and others will be given in more details later in this assay.9 Peter k. Nevitt and Frank J. Fabozzi, Project financing (7th end, Euromoney Books,London 2000) p30510 Scott L. Hoffman, The law and business of international project finance (Cambridge University press, Cambridge 2008) p 38

4

B is almost certain to enter into a credit agreement with P in which the former

arranges to loan P a certain amount of money to finance most of the cost of the

project. Typically, the loan will be repaid from revenues of the project either after

completion or over the life of project from the take-off agreement. P, in turn, will

confer the creditor bank an exclusive recourse to its assets in event of the project

company failure to fulfil its financial obligations toward the bank, besides a number

of interest securities.11 The credit Agreement is high likely to contain provisions in

respect of interests rate, events of default, submission to jurisdiction (in this case

English law), the debt payment currencies and so on.12 Yet, there will be a shortfall in

the project funding where R will be willing to lend P as subordinate creditor. Thus,

entering into an Intercreditor agreement13 with B.

2.3. BOT Agreement

The BOT (build, own, transfer) agreement14 is a contract between the project company

and the host government, in which the latter grants a concession to P for a

predetermined period in order to permit it to build and operate the project15. Under

this agreement R transfers the land to P provided that it is to be retransferred after the

specified period. However, Ruritania government must observe that this period ‘being

as long’ is needed to enable P to fully repay the finance as well as acquiring a

reasonable profit margin.16 The BOT agreement is high likely to contain provisions

such as the authority (R) will provide the necessary land on lease for the concession

period, the authority will ensure that planning and other official permits are available,

the company (P) will comply with official permits and with local safety and

environmental law etc.17

2.4. Construction Agreement

11 Phillip Wood , Project Finance, Securitisation, Subordinated Debt (2nd end, Sweet & Maxwell, London 2007) p512To further details please see Scott L. Hoffman, The law and business of international project finance (Cambridge University press, Cambridge 2008) p 32813 An agreement among creditors agreeing how their competing interests in their common borrower will be approached.14 Also known as a concession agreement, implementation agreement or BOOT agreement15 Jeffrey Delmon, Project finance, BOT projects and risk (Kluwer Law Intl, UK 2005) p 6316 Wood, P. Project Finance, Securitisation, Subordinated Debt, op.cit. p1717 Ibid. p17-18

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The construction agreement is a formal agreement between the employer (P) and the

contractor (C) in which C agrees to build the project in a definite period and for a

specific amount of money which high likely to be paid in stages according to the

progressing of the construction.18 It generally contains provisions in respect of the

completion such as the contractor will complete the project by date X, the completion

date will be extended in certain circumstances (mentioned in the contract) etc.19

2.5. Off-Take Agreement

In order to make this project bankable, the project sponsors may agree to sell, in

advance, the products of the project to S under a long term off-take agreement. The

yield of this agreement is often used to repay the debt as well as to pay the profits to

the shareholders. Method of payment for these products may have to be paid in

advance or gradually according to the milestones of the project's progress.20 However,

such agreements are often include terms in respect of sale, price, and terms of the

contract. For example, P will sell electricity to the S in the X quantities, at the X time

and according to the agreed specifications.21

18 Ibid. p519 Ibid. p23-2420 Hoffman, S. op.cit. p 33021 Wood, P. Project Finance, Securitisation, Subordinated Debt, op.cit. p28-29

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3. Risk Identification

It is advisable for host governments that are looking forward to take a part in project

finance transactions, as is the case with R, to be keenly aware of the major inherent

risks arising whether during the structure phase or after the project has been

completed. Also, in order to make this project bankable, it is a matter of importance to

allocate and address these risks properly. Fundamentally, there are three main

overarching risks in typical project finance which could negatively affect the success

of the project.

3.1. The Risk of Non-Completion or Delay

One of the major risks that may encounter the project, during the construction phase,

is the risk of non-completion the project on the predesigned time which might occur

as result of many reasons such as cost overruns,22 technology failure, force majeure

and so forth. Construction delay can, also, cause serious problems for the project,

particularly by amplifying the debt interest of the project, increasing the costs of

labour, paying penalties under the project contracts etc.23 Typically, C will be the

selected party to bear this risks very often by providing a type of contract bond,

usually performance bond, which is a form of surety issued by a third party under

which the surety party undertakes to conduct the financial obligation to P in event of

the S failure to fulfil its obligations toward the former.24This performance bond is

often would be coupled with the construction agreement (mentioned above).

3.2. Market Risk

Market risk, also known as systematic risk, is a risk that is related to the fluctuating in

financial market prices in respect of the input supply cost, output price (the price of

the project sales), interest rate and exchange rate.

22 The costs of a project are higher than the estimated expenditure.23 Esteban C. Buljevich and Yoon S. Park, Project financing and the international financial markets (Kluwer Academic Publishers, US 1999) p 14524 Richard Hudson Clough, Glenn A. Sears and S. Keoki Sears, Construction project management (4th end, Wily and sons Canada 2000) p 50

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3.2.1. The Output Price Risk

The financing bank will demand a level of certainty in term of the output price in

order to obtain its debts. In this project such demand can be approached through a

long term off-take agreement between Project Company and Sealandier otherwise by

future or forward contracts.25

3.2.2. The Input Supply Risk

The input supply risk will be addressed to some degree by two main methods. First,

through the input supply agreement in which the project supplier will be obliged to

furnish P with the materials necessary for the project. Such agreement usually covers

the quality, quantity and the price of the input. P, thus, will be isolated from the

market risk in term of price as well as the availability of the input.26 Second method to

approach this risk is by matching of contracts. According to the matching principle S

bears this risk by incurring the value of the project product including the project costs

and the loans regardless of whether the project has produced or not. Such costs may

include the fuel or raw material costs, debt service cost, operating cost etc.27

3.2.3. Interest Rate Risk

The sponsors of the project company must take into account all foreseeable fluctuation

of interest rate that might occur during the life of the project and be prepared to

accommodate it by the estimated revenue of the project. Yet, there is a risk of higher

interest rate than what was anticipated. This risk can be mitigated by transferring it to

a creditworthy party often through the interest rate swap28 agreement under which the

project company agree to exchange its interest payments, which based on floating

interest rate, with a counterparty which its interest payments are based on fixed rate.

Thus, P pays the fixed-rate interest payments of the counterparty and the counterparty

in turn pays the floating rate interest payments to P which are passed ultimately

through to B.29

25 Buljevich, E. op.cit. p 15126 Delmon, J. op.cit. p 6527 Wood, P. Project Finance, Securitisation, Subordinated Debt, op.cit. p 628 Also known as coupon swap agreement29 Wood, P. Project Finance, Securitisation, Subordinated Debt, op.cit. p 153-154

8

Both of payments often pay at set intervals over the life of the interest swap

agreement. Also, the interest rate risk can be addressed by passing it through to S

according to the matching principle (mentioned above in the context of the input

supply risk).30

3.2.4. The Exchange Rate Risk

It occurs when the currency in which the project products are sold differs from the

currency of debt repayment. Thus, any decline in the value of the former currency will

lead to failure to cover the loan by the sale proceeds. Under project finance S as a

purchaser can deal with this risk usually by buying the project products in the same

currency of the original debt.

30 Ibid. p 153-154

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3.3. Political Risk

Political risk is the probability of loss because of unwanted consequences of political

changes in the Ruritania as a host country. These changes may lead to adversely

intervene of Ruritania government to change the BOT agreement or even expropriate

the whole project finance assets31.

In this context, mitigating political risk can take two practical forms. First, by

demanding a guarantee given by R under which R undertakes to perform all its

obligations toward P.32 This guarantee can, also, given by foreign creditworthy party.

Second, adopting investment protection treaties between the sponsors' government

and R.33 Third, by acquiring a political risk insurance that protects the lenders as well

as the sponsors of P from the risk of interfering the host government whether by

changing its policies and regulations such as increased taxes or royalties, changes to

the concession agreement, sales in local currency only or even by expropriation of the

project assets.34

The price of this insurance is high likely to depend on the level of the political

instability of the host country.

31 Stephen J. Kobrin,'Political risk: A review and reconsideration' (1979) Butterworths Journal of International Business Studies 6732 Nevitt, P. op.cit. p 305,31733Wood, P. Project Finance, Securitisation, Subordinated Debt, op.cit. p 734 Ibid. p 7

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3.4. Insolvency Risk

The probability of loss due to one of the project finance parties is unable to service its

debts.35 Such insolvency might lead other party to cancel its contract. For example S

might be reluctant to conduct its obligations toward P if the later becomes insolvency.

This risk will expose in the first place B as a main creditor who depends primarily on

the revenues of the project. So it is utmost important to the bank that all the

requirements of the project has been satisfied to carry out the project regardless of a

particular counterparty becomes insolvent. In doing so, there is a variety of security as

well as arrangements will be sought by the bank.

However, there are many other secondary risks that R might take into account such as

technology risk ( if the project engages new unproven technology which may fail),

causality risk (risk of damage), operating risk (related to manpower costs,

maintenance and so on) and environmental risk (pollution and clean up costs).

35 Ibid. p 8

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4. Security Interest

It is generally agreed that B will finance the project by a nonrecourse loan. So it is

essential for the bank to have the best available security over the assets of P in order

to be entitled in the event of insolvency to stand first in the order priority and realising

the assets to cover its secured debt. In this context, the term 'security interest' can be

defined as an exclusive legal recourse to a particular collateral that has been pledged36

in advance often under the credit agreement.37

As the English governing law and the jurisdiction of the English courts has been

agreed to apply to the credit agreement, the project company can be lawfully create a

charge over all its assets to secure its debt that will be given by B. Adopting the

security interests well undoubtedly shield the secured debt in the event of

insolvency.38 Thus, the capital will be induced to engage, the cost of credit will be

reduced and the bankability of the project will be enhanced.39 However, the major

forms of security interests that B is high likely to require under English law are as

follows:

4.1. Mortgage Security

Basically, the first security interest that the bank will look forward is the mortgage

security under which the bank secured lawfully its loan by some specified real estate

property in Ruritania such as the land where the project is grounded on.

4.2. Assignment by way of security

Under the Off take agreement S as a customer owes P for the electricity purchased on

credit. This money financially so called, 'Accounts Receivable' and considered as a

current assets of P. Therefore, B will seek a direct assignment from P under which the

right of receiving payments from the customer will be transferred temporally to B

until its debt has been satisfied.40 Typically, B may notify the costumer of its right to

receive the payments upon request instead of P under its security arrangement with

36 has been agreed to palace an assets as a collateral for a loan.37 Philip Wood, Law and practice of international finance (Sweet and Maxwell, London 2008) p 28438 Ibid. p 284-29439 Ibid. p 250-25140 Finnerty, J. op.cit. p 90. Also, Wood, P. Law and practice of international finance op.cit. p 145-153

12

the latter in this respect41 (see figure 2). Assignment by way of security is lawful

according to Law of Property Act 1925 (c.123).

4.3. Security on Special Bank Account

Practically, the received payments by the costumer are often placed in a special bank

account (SBA) before it is paid back to P. Unsurprisingly, B will seek a form of

security on this valuable asset by two methods. First, by obtaining a right of set-off

under which the B is entitled to offset amounts that owes to P against obligations that

the latter owes to the former.42 Second, by requiring 'fixed charge' on SBA under

which B acquires lawfully an exclusive recourse to SBA in the event of insolvency of

P.43 Also, withdrawing money from SBA will need a permit from B according to

English law (see figure 3).

4.4. Novation

It is a matter of importance to B that C is bound to the construction agreement even if

P became insolvent. So that, the credit agreement is very likely to contain a provision

whereby P may novate or replace its rights and obligations to B44. Also, C must be

approved for this 'Novation' in its construction agreement with P. Thus, in the event of

insolvency of the project company, C will be required to enter into a new agreement

with B to build the project on the same terms of the construction contract originally

agreed upon. B in turn will make payments to C instead of P (see figure4).45

41 Wood, P. Law and practice of international finance op.cit. p 14942 Ibid. p 21843 Ibid. p 22244Ibid. P154 45 Ibid.

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5. The position of the Ruritania government as creditor in the insolvency

As there will be a shortfall in the project funding where R will be willing to lend P as

subordinate creditor. Thus, entering into an Intercreditor agreement with B.

5.1. Intercreditor agreement (turnover subordination agreement)

It is utmost important for B as a main creditor that it has priority, in the event of

insolvency of the project company, over other creditors, especially when the security

is inadequate. Therefore, B is almost certain to take a part, in advance, into

Intercreditor agreement46 with R, as one of the creditor, under which R is welling to

be classified as a junior or subordinated creditor to B47. R must be realised that its loan

to P will be unsecured and has no collateral which mean that it will be ranked after B

who considered as a secured creditor (super priority creditor) in the bankruptcy ladder

of priorities under English law, thus it might receive little or nothing of its debt.48

In addition under the turnover subordination agreement R will be agreed to not claim

or receive payments until the claims of B has been paid in full. Also, to be agreed to

claim its payment and turn it over to the senior creditor when the latter demand that49.

In fact, such agreement will be restricted in terms of the payment of the junior debt.

Hence, it might include provision such as the junior creditor will not receive any

distribution in respect of the junior debt in cash or kind from the debater or any other

source, except for permitted payments and when required by this agreement to receive

them and turn over to the senior creditors.50

46 also known as turnover subordination agreement47Ibid. p 848 Philip R. Wood, Principles of international insolvency (2nd end, Sweet & Maxwell, London 2007)p283,286 49 Wood, P. Project Finance, Securitisation, Subordinated Debt, op.cit. p 212-24150Wood, P. Project Finance, Securitisation, Subordinated Debt, op.cit. p 214

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6. Conclusion

This assay has briefly examined the nature of the project finance transactions in the

context of providing a comprehensive advice to the Ruritania government in its intent

to participate in a project finance transaction. Also, it has knocked on all relevant

issues of this transaction including the probable contracts that will be agreed, the

methods of mitigating the wide spectrum of inherent risks and a number of interest

securities sought by the financing bank. Furthermore, It has shed some light on the

position of Ruritania government as a subordinate creditor in the event of insolvency.

Fourth sets of conclusions can be drawn from the exposition above.

First, for the sake of remaining bankability (acceptable to the bank) of the project, P

must be excluded from incurring contractually any form of risks. If P exposed to a

risk than, in effect, the risk is incurred by B since the latter rely basically upon the

former revenues to obtain its debts.

Second, R must recognise the different roles and obligations that it will bear whether

as a host country, a creditor or a sponsor of P.

Third, in terms of security, P must insure that its contracts rights with other parties

are, as far as possible, assignable including performance bond. the consent to

assignability is a key component in this respect, otherwise B will be reluctant to

finance the project. Not to mention that these contract must be legal, valid ,binding

and enforceable under English law.

Equally important, fourth, B has to perfect its security by following the required

procedure to secure or record its interests in R.

15

BIBLIOGRAPHY:

1. John D. Finnerty, Project financing: asset-based financial engineering (2nd

end, Wiley, New jersey 2007)

2. Catherine Pedamon, ‘How is Convergence Best Achieved in International

Project Finance’ (2000-2001) 24 Fordham Int'l L.J.

3. Michael P. Malloy ‘International Project Finance: Risk Analysis and

Regulatory Concerns’ (2004-2005) 18 Transnat'l Law.

4. Graham D. Vinter, Project finance: a legal guide (3rd end, Sweet and

Maxwell, UK 2007)

5. Peter k. Nevitt and Frank J. Fabozzi, Project financing (7th end, Euromoney

Books,London 2000)

6. Scott L. Hoffman, The law and business of international project finance

(Cambridge University press, Cambridge 2008)

7. Phillip Wood , Project Finance, Securitisation, Subordinated Debt (2nd end,

Sweet & Maxwell, London 2007)

8. Jeffrey Delmon, Project finance, BOT projects and risk (Kluwer Law Intl, UK

2005)

9. Richard Hudson Clough, Glenn A. Sears and S. Keoki Sears, Construction

project management (4th end, Wily and sons Canada 2000)

10. Stephen J. Kobrin,'Political risk: A review and reconsideration' (1979)

Butterworths Journal of International Business Studies

11. Philip R. Wood, Principles of international insolvency (2nd end, Sweet &

Maxwell, London 2007)p283,286

12. Philip Wood, Law and practice of international finance (Sweet and Maxwell,

London 2008)

13. Philip Wood, International loans, bonds, guarantees, legal opinions (Sweet and

Maxwell, London 2007)

14. Philip Wood, Set-off and netting, derivatives, clearing systems (Sweet and

Maxwell, London 2007)

15. Philip Wood, Comparative law of security interests and title finance (Sweet

and Maxwell, London 2007)

16. Gerard McCormack, Secured Credit under English and American Law

(Cambridge University press, Cambridge 2004)

16

- Figure 3

- Figure 4

17

Bank

Special Bank Account

Set off

Fixed Charge Project Company

Bank

Project Company

Construction company

Construction Agreement

Make Payments

Fulfilled its Obligations

-Figure 2

18

Bank

Project CompanySpecial Bank Account

Customer

Accounts Receivable

Creditor

Debtor

Payments

S.123 LPA act 1925

Notice

Appendix

- Figure 1

19

Ruritania Government

Construction Company

Sponsor

Host country ContractorCreditor

BOT Agreement Construction Agreement

BANK SealandierCredit Agreement Take-off Agreement

Intercreditor Agreement

Supplier

Supplier Agreement

Sponsor

Joint Venture Agreement

Project Company