GENERALLY

Selection of the form of business organization for the project company is an important step in project development. The type of entity selected affects many aspects of project development and financing, such as the drafting and negotiation of the project documentation and the regulatory permitting process.

For example, permits granted to the project sponsor and later transferred to a new project company may no longer be valid in some jurisdictions. This is because the ownership of the project has changed. Also by example, a project contract that prohibits assignment of the contract from one entity to another may preclude a later transfer to the entity that will actually operate as the project company. Thus, the project company, whatever the form, should be organized as early in the development process as possible to avoid these concerns.

Where to organize the project company is also an important consideration: under the laws of the host country or under the laws of the project sponsor's organization. In making this determination, the advantages and disadvantages of each country's laws should be examined, as well as the tax treatment of the entity.

PRE-DEVELOPMENT ACTIVITIES

Generally

Before a project sponsor begins full development of a facility, a thorough examination of its feasibility is undertaken. During this period, both technical and financial feasibility are evaluated. To make this analysis worthwhile, a fair amount of time and resources must be invested. The factors considered in a feasibility study are discussed in detail in Chapter 8.

PROJECT SPONSOR

The project sponsor is the entity, or group of entities, interested in the development of the project and that will benefit, economically or otherwise, from the overall development, construction, and operation of the project. It is sometimes called the developer. The project sponsor can be one company or a group of companies.

PROJECT COMPANY

The project company is the special-purpose entity that will own, develop, construct, operate, and maintain the project. The precise nature of organization for this entity is dependent upon a myriad of factors.

Of foremost concern is the local law of the country in which the project is based. The local law must be examined to determine, for example, whether a form of organization is prescribed; whether a foreign entity can do business in the host country; whether a foreign entity can own real property in the host country; the extent to which liability limitations, such as is enjoyed by a corporation or limited liability partnership, is permissible; requirements for local investor participation in the entity organized in the host country; and similar concerns.

Other factors also influence the selection of the form of organization for the project company. These include tax laws in the host country, tax treaties, and foreign exchange rules of the host country.

INTRODUCTION

Bankruptcy of a project participant with assets in the United States and another country or bankruptcy of a project participant with assets only in a host country presents a complicated risk for creditors. The risk includes the availability of ancillary proceedings in other countries and whether other countries recognize another country's bankruptcy proceeding. Unfortunately, there is no universal bankruptcy code.

For international projects, bankruptcy reorganization in the sense common in the United States is not generally available. This is because one jurisdiction cannot typically assert overall control of the project's reorganization.

TYPES

Two general theories of bankruptcy protection when a debtor's creditors, assets, or both are located in another country are universal and territorial. An understanding of these theories assists in an understanding of the risks in transnational project finance.

Universal

Countries that base their bankruptcy laws on a universal approach embrace the theory that the law of the country in which the bankruptcy is pending should be paramount. All of the debtor's creditors would therefore be required to participate in one proceeding. That proceeding's determinations are considered to have international effect.

Territorial

At the other extreme, countries that embrace the territorial theory consider bankruptcy law to apply only within the borders of a country. Therefore, a debtor with multinational operations would pursue bankruptcy proceedings in several countries. The bankruptcy decisions rendered in other countries concerning the same debtor would not be applied.

INTRODUCTION TO CREDIT ENHANCEMENT IN PROJECT FINANCINGS

In theory, a project financing can be structured in which there are no risks and the lenders are content to rely solely upon the revenue-producing project contracts to service debt. In reality, of course, the discussion of project finance risks described in Chapters 2, 3, and 4 evidences that mere reliance on those contracts is insufficient to protect the lender from equity risk. Credit support, or enhancement of credit as it is sometimes referred to, from a creditworthy source is necessary.

The purpose of credit enhancement is to improve the most severe equity and lender risks in a triage of project financing risks identified. Depending on myriad factors, the requisite support can take the form of direct guarantees by the project sponsor or the project participants, guarantees by third parties not directly participating in the project, and in some cases contingent guarantees and so-called moral obligations of the project participants.

The most obvious type of commercial risk in a project financing is the risk of nonpayment of the project debt. Commercial risks must generally be covered by credit support of the project sponsor or a responsible third party. Although the project sponsor is conceptually the fundamental risk taker, the nonrecourse nature of a project financing limits the ability to allocate risks to the sponsor. While a sponsor may be asked to accept directly some risks, it most likely will also be asked to provide additional equity contributions upon certain specified events, and to provide credit enhancement in the form of insurance, third-party guarantees, or letters of credit in others.

INTRODUCTION

The word bribery carries with it different meanings, depending upon the values and practices of the country involved. In the West, bribery of governmental officials is viewed as economically inefficient, politically destabilizing, morally corrupt, and, of course, illegal. In other countries, bribery has been endemic – a necessary evil in accomplishing business goals. By 1977, the United States viewed bribery as no longer acceptable in the global marketplace. The U.S. Foreign Corrupt Practices Act, which came on the heels of the Watergate and Lockheed scandals in the United States, made illegal the bribery of foreign officials to obtain or retain business. Yet, the United States stood alone in its efforts.

The effects of anti-bribery statutes are mixed. On the one hand, they provide an effective shield to a company against bribery attempts or threats; that is, the company can argue that bribes are illegal in its home country. Such illegality could potentially subject the officer or employee to criminal punishment, as well as embarrass the host country's government. On the other hand, unless parallel prohibitions are in place for foreign competitors, the prohibition places the company at a competitive disadvantage. At least one study suggested that U.S. companies lost almost $45 billion in contracts as a result of the prohibition.

PURPOSE

As a first step in seeking commitments for project debt from financial institutions, the project sponsors prepare an offering memorandum. The memorandum explains the project to potential lenders. It includes the following general topics: experience of the project sponsors; the identity and experience of the major project participants, including the contractor, operator, suppliers, and off-take purchasers; information on the host government; summaries of the project contracts; project risks and how the risks are addressed; proposed financing terms; the construction budget; financial projections; and financial information about the project sponsors and other project participants.

KEY PROVISIONS

This chapter sets forth a discussion of each of the major provisions of a debt offering memorandum used commonly in international project finance transactions.

An offering memorandum is sometimes used to raise equity for investment in the project. Such an offering memorandum is nearly identical to a debt-offering memorandum and emphasizes the proposed equity terms.

PROJECT OVERVIEW

A brief description of the proposed project is included first in the memorandum. The overview includes the type of project, background on the host country, the status of development, and other significant information.

The project finance industry has undergone many changes and challenges since the first edition of this book was written in 1997. During this time, there has been an amazing growth in project finance among multilateral and bilateral agencies, governments, financial institutions, rating agencies, and development companies. The financing of infrastructure projects in developing countries was in its infancy in 1997 and since then has experienced many great successes and a few failures.

Project finance is now a recognized course offering at business and law schools throughout the world. As seen in the Select Bibliography to this edition, the scholarly research is expanding, as are general books about project finance.

This third edition is a complete update of the first and second editions, including all of the major developments in project finance over the past decade. It is my hope that this book will continue to be useful as a college course book for students sufficiently curious to wonder what project finance is about, a training tool for those thrown into the world of project finance, a research tool for those needing a project finance treatise, and a structuring and drafting tool for those involved in transactions, including project finance counsel, lenders, government agencies, project sponsors, and equity investors.

INTRODUCTION

In a power project, a power sales agreement, or power purchase agreement as the purchaser calls it, is the linchpin of an energy project financing. This agreement sets forth the obligation of the project company to produce power for sale and for the power purchaser to buy it. It is from this transaction that the funds flow to pay debt service, operating costs, and an equity return. It must fulfill, therefore, the dual role of financing document and operating document.

The funds, of course, will not flow unless the power purchaser is creditworthy; that is, the power purchaser must have sufficient cash to pay its bills, as proven by past, present, and expected future financial performance. To the extent that this is not present, credit enhancement, such as a guarantee by a creditworthy central government or multilateral support, is needed.

REVENUE CONTRACTS IN TRANSNATIONAL PROJECTS

In some countries, a project financing, which is based on the underlying cash flow from the revenue-producing power contracts of the project is a new concept. Project finance contract provisions that are standard in the United States and Great Britain are either not yet developed, or relatively recent in concept, in these countries. An example of this type of provision, considered essential to a successful energy project financing, is a definitive obligation for a utility's purchase of the project's energy output at a defined price.

THE ROLE OF COLLATERAL IN A PROJECT FINANCING

Generally

The project finance structure, like most asset-based transactions, is centered on the assets of the borrower. Like all lenders, project finance lenders take collateral from a borrower so that if the loan cannot be repaid the collateral can be sold and the proceeds applied to loan repayment. In a project financing, the collateral documentation cannot be overlooked or its value minimized. Yet, the unlikelihood of disposition of a troubled project in a liquidation sale that recovers the full loan amount must be clearly understood.

Collateral as a Defensive Tool

The project lender desires the right to take control of the assets necessary to finish construction, operate the project, or sell the entire project in a liquidation so that another entity can operate the project and apply the proceeds ahead of all other creditors to repayment of its loan. Preserving all the elements of a project is usually necessary to achieve this goal.

Project lenders have additional goals in taking a security interest in all of the project company's assets. The lender desires that the project assets not be sold or otherwise disposed of without its consent, thereby ensuring that important assets are available to operate the facility or are sold for a price that allows replacement. In addition, for the same reason, the lender does not want any third party to have rights to any of the project's assets.

GENERALLY

Contracts are king in project finance. Perhaps no commercial contracts are more discussed and analyzed in the financing context than those used in project finance transactions. Because nonrecourse and limited recourse project finance are based on the predictability provided by the contract structure, project sponsors and lenders are all interested in the risk allocation and other contract terms.

It is not an overstatement to write that every term of a project finance document is significant for the project participants. Examples of important project finance provisions are

• restrictions on the use or sale of any project asset;

• restrictions on the right to receive or use project cash flows;

• grants of security interests or similar collateral security rights to any party other than the project lender;

• short cure periods for defaults or restrictions on automatic terminations without any cure periods;

• force majeure provisions; and

• transferability of project documents following a foreclosure.

The following chapters in this part of the book contain summaries of the significant documents in a project financing. Although the documents might seem to be a bit overdone, do not be too confused or disheartened. One author commented:

Generally

The construction contract in an international project financing serves to give the project company a fully completed and equipped facility. In addition, it provides for delivery by the contractor of a facility that satisfies specified performance criteria, for a fixed or predictable price, and completed on a specified date. To do so, the contract typically requires the contractor to provide all engineering and construction work, procurement of equipment and supplies, and start-up and testing.

The tension between the project company and contractor in a project financing is based on the turnkey nature of the construction contract: The contractor must deliver the project at a fixed or predictable price, on a date certain, warranted to perform at agreed levels. The contractor is, of course, concerned with the difficulty of predicting events that could delay project completion, increase the price, or reduce guaranteed performance. Thus, unless the contract price is extremely attractive (that is, the risk premium sufficiently high), significant objectives of the contractor in contract negotiation are to limit risks of any increase in the cost of the project, to ensure there are sufficient contractual excuses for late delivery, and to provide sufficient time to satisfy performance guarantees.

A customary reward to the contractor, in return for assuming these price, delay, and performance risks, is through a bonus payment. The project company pays a bonus payment to the contractor if the project is completed ahead of the scheduled completion date. In a project financing, the bonus concept must conform with the rights and obligations of the project company under the other project contracts.

GENERALLY

Project finance structures are virtually unlimited by the creativity and flexibility of bankers and lawyers. Largely, the structures are influenced by the risk appetites of the lenders and investors involved in the financing and by the economic condition of the host country.

In general, these structures are based on one of three macro varieties: nonrecourse financing, limited recourse financing, and project output interest financing. Nonrecourse and limited recourse financing structures provide for debt repayment from the cash flows of the project. Output interest financing structures are centered on the purchase of an interest in the project output, which purchase price is used, in part, to finance the facility.

Within these three broad categories are countless other structures, on a micro level. The most frequently used of these, loan financing, export credit financing, lease financing, and bond financing are discussed in this chapter.

COMMERCIAL LOAN FINANCING

The general structure of a loan financing in the project finance context is not unlike the structure used in other loan transactions. In the typical project finance transaction, funds are lent to the project company for the construction and operation phases of a project.

GENERALLY

A project sponsor has two options for project operation. It can decide either to operate the project itself, without an operating agreement, or retain an operator to operate the project for it. If the project company retains an operator, it is sometimes an affiliate of a project sponsor.

Operating Agreement

Similar to the project finance construction contract, operation and maintenance agreements in international project financings must serve to provide the project sponsor with a facility that performs within certain agreed-upon performance criteria, and that operates at a fixed or reasonably predictable cost. Similar to the contractor's responsibility in a project, an operator should likewise be responsible for all aspects of project operation and maintenance.

As discussed below, the risk that operating and maintenance costs will exceed the budgeted estimate and the funds available from project revenues is a significant risk in a project financing. If operating costs exceed estimates, the additional money needed for project operation will need to come from reserve accounts, if there are any, or from funds that would otherwise be used to pay debt service or distribute to the equity owners.

Project finance operation and maintenance agreements typically contain each of the following provisions: a detailed scope of work; a fixed or variable (but predictable) price for all of the work necessary to operate the project; performance guarantees; liquidated damages for failure to satisfy performance guarantees; and a showing of financial creditworthiness of the operator.

INTRODUCTION

The host country for a project is involved, knowingly or unwittingly, from the start of project planning. Governmental involvement can take many forms, ranging from enacting laws that regulate a project to ones that encourage sector reform, such as through private development, build-own-transfer (BOT) structures, or privatization. In the operation stage of a project, government involvement continues, through varying levels of continuing regulation for some projects, and even non-regulation for others.

Infrastructure projects – roads, railways, ports, energy production, hospitals, and airports – heighten the interest and involvement of the government in the project's development, construction, operation, and financing. Projects less tied to the country's infrastructure needs, such as industrial projects, may involve government interest and cooperation, but often at a less significant level. Even industrial projects sometimes attract governmental interest beyond job creation and tax revenue, such as in projects where a government-controlled fuel company will supply project fuel.

The interest level of the host government in a project will affect its ability and commitment to execute support agreements for the project; institute sector reforms, such as privatization; and enact legislation needed to make a project feasible. In this chapter, the processes governments use to solicit private-sector interest, and the procedures and agreements typically used by governments to support the development of projects and encourage foreign investment, are explained.

GROWTH OF ENVIRONMENTAL REGULATION

Generally

Environmental issues are an important aspect of transnational project development, construction, and operation. Increased project construction and operation costs, capital costs related to retrofitting equipment to satisfy new standards, civil and criminal penalties, and securities law violations can each have significant effects on a project and its sponsors.

Environmental laws and regulations have applicability beyond the project itself. They can also apply to the products produced by the project and the waste and other byproducts generated.

Host Country

Local, state, and central governments are increasingly protective of the environment, particularly in the areas of air and water pollution and waste disposal. The degree of implementation and enforcement of these protections varies.

Multilateral and Bilateral Institutions

The World Bank and other multilateral and bilateral institutions, such as the African Development Bank, the Asian Development Bank, and the Inter-American Development Bank, consider protection of the environment a necessary component of their activities. As a result, many governments and multilateral and bilateral institutions require that the effect of a project on the environment be considered and approved before construction begins or money is lent to the project.