Apr 12, 2016

Legal & Commercial Issues in International Project Finance By Adetutu Oluwaseyi

International Project finance typically involves multiple parties from different jurisdictions with conflicting interests that must be protected and obligations that must be clearly defined. The structure of project finance loan can be limited recourse or non-recourse to the project sponsors. The underlying rationale is to distribute risk among the participants involved. In cross border transactions, it is important to anticipate and properly analyze the possible risk the project could be expose to in the host state and identify solutions that can be used to mitigate or eliminate the impact of the risks. In order to mitigate or reduce the risks associated with jurisdictional issues, clauses should be incorporated in the contract agreements between the counter parties at different phases of the project.  The contracts include- Sponsor Support Agreement, Loan Agreement, Collateral Security Agreement, Power Purchase Agreement (PPA), Engineering Procurement and Construction (EPC) Agreement, Operations and Maintenance Agreement (O & M), Fuel Supply Agreement, Concession Agreement, Management Agreement, Joint Venture Agreement and Shareholders' Agreement. The following issues and questions can be identified from the above scenario:
1.     What are the applicable laws and institutional framework that will govern the project in the host country?
2.     What structure should the business transaction take?
3.     What will be the currency of the transaction since the financier and project will be based in different jurisdictions?
4.     What is the profitability of the project?
5.     What is the structure of the project loan?
6.     What is the political history of the host country?
7.     What are the other risks to be considered in that jurisdiction and how can the project be secured from such risks?

Possible approaches to address these issues are discussed below:

These are policies and regulations of the host state designed to regulate cross-border transactions. It is important to have a comprehensive knowledge of the underlying legal and institutional framework regulating the establishment of international projects in the host state as this varies depending on the particular jurisdiction. It is advisable for parties to take out the services of a local counsel to get advice on the host state legal and investment environment. Generally, applicable laws may encompass:

·        Domestic laws: Information relating to the Commercial laws, Law of Corporate Governance, Labour Laws, Land Laws, Property Acquisition, Tax Regime, Environmental Laws, Immigration, Customs and Industry.

·        Administrative Framework: Information on the relevant governmental organs saddled with the responsibility of administering international power projects, e. g obtaining license, approvals, permits, the quality of public administration, transparency of the system local regulations and system of dispute settlement.
  • International Standards: Applicable laws will also include guarantees provided by the host state for protection of foreign investments under any international standards. These standards can be provided on the platform of a Bilateral Investment Treaty (BITs) or Multilateral Investment Treaty (MITs) involving the states of the parties involved in this transaction. For instance, under the World Trade Organisation Framework (WTO), the General Agreement on Trade in Services (GATS)[2] will apply where services are provided by an investor of a member through the establishment of a service provider in the territory of another member.
·        Agreement and Language: It is essential to identify the contracts and the language of the contracts between the parties. The loan agreement is usually in the language of the lender, while the collateral security agreement is usually in the language of the host state as the collaterals are most likely located within the same jurisdiction as the project.

·        Choice of Law Clause: It is important that parties mutually choose the law governing the contracts underlying the project development and incorporate in the contracts of agreement.[3] The foundation of project finance is originally a joint venture agreement between two parties which will invariably extend to other parties in order to spread the risk involved. Therefore, to protect each parties involved at every stage of the contract will require contracts agreement designed to cover the choice of law clause governing the transaction, insurance safeguards and settlement of investment dispute between the parties. Parties have the flexibility to build protective clauses in the agreement to secure their rights and interests under the contract.

·        Dispute Resolution: Due to the fact that many participants from different jurisdictions are involved in negotiating separate contracts at different phases of the project that will form a global structure with links, it is essential to safeguard the whole network of contractual relationship by anticipating dispute among the parties and incorporating a mechanism of resolving such dispute in event of occurrence.[4] Parties may first resort to non-binding informal consultation (mainly, conciliation and mediation) before proceeding to the binding structured (judicial forums and arbitration) means of dispute resolution.[5] Non-binding mechanisms traditionally offer the flexibility that international market participants require to protect future relationships while binding mechanisms offer the judicial implementation of the rules set forth in applicable statutory law and in the contracts between the parties. [6] Parties to international contracts more often than not utilize two types of forums namely domestic courts and international arbitral tribunals. During negotiation, it is important that parties agree on the choice of forum and choice of law to be applied by the forum in the event of dispute and incorporate in the contracts between the various parties.

Project finance is a platform on which certain projects are financed off the balance sheets of companies.[7] It is a specialized funding structure that relies on the future cash flow of a project as primary source of repayment without recourse to the project sponsor’s assets for the debts or liabilities of the project.[8] It holds the project’s assets, rights and interests as collateral security.[9] The design of the joint venture between the sponsors is established by the joint venture contract for the purpose of jointly financing the project. The structure selected by the sponsors is important in project finance because it has implications on a number of things including ownership, management, roles and responsibilities of the sponsors, equity contribution, license and permits, documentation, location, termination and consequently financing.
·        Special Project Vehicle (SPV): A joint venture does not have legal personality. In order to create a platform on which the power project can be floated without encumbering the balance sheet of the two sponsor companies, a Special Purpose Vehicle (SPV) that will implement the project and raise the funding should be created.[10] Establishing a SPV mitigates project risks and shields the sponsor from adverse developments. The nature of the organisation of the SPV depends on many factors including the laws of the host state.

·        Incorporation: The SPV should be registered and incorporated to give it a legal personality and becomes independent from its sponsors. This provides a safeguard for the project in the event of failing shareholders dragging a healthy project into distress or vice versa. The sponsors will typically incorporate the project company in the most attractive jurisdiction from a regulatory perspective that allows the sponsors to continue to own and operate the project company or holding company.
  • Management and Control: It is important to determine the concept of ownership and control of a company under the laws of the host state in order to determine the structure of shareholding of the company. A due diligence on the ownership structure to determine what form of organisational structure is prescribed and foreign participation in host country’s companies will determine the shareholding capacity of the sponsors and their equity contributions. The management of the project company and the relationship between the project sponsors should be specifically spelt out in the management agreement.
·        Equity Contribution: The equity contributions of the sponsors should be specifically stated in the shareholders’ agreement to ascertain the timing and certainty of the equity funding in order to optimally schedule the timing and dependability of the injection of funds into the project.
·        Effective place of Management: The sponsors of the project company have different jurisdictions. It is important that the place of effective management of the new company be spelt out in the management agreement to determine its nationality and place of control.
·        Insolvency: Insolvency is the most crucial indicator of the attitude of a legal system in its commercial framework.[11] It has a profound impact on legal relationships. This signifies the importance of counter-parties having a prior understanding of their positions in the event the project company goes insolvent.[12] The divergences always focus on priority, property, contract and liability. Under the common law jurisdiction, emphasis is on rescue and re-organisation. In contrast in civil law jurisdictions, the insolvency process focuses on winding companies up. One way to determine the rights and liabilities of counterparties is to negotiate the choice of law that will apply in case the project goes bankrupt and incorporate in the Loan agreements and Shareholders’ agreement. Parties may consider the adoption of the 2005 UNCITRAL Model Law on Cross-Border Insolvency.
  • Tax Regime
The tax policy of the host state has considerable effect on the profitability of Project finance.[13] It is important to structure the project in such a way that it will take advantage of tax benefits in the host country. This will include analysis and use of double taxation treaties, privileges under bilateral and multilateral trade treaties. The place of effective management and incorporation is also important for tax purposes.
  • Obtaining Operating Licences and Permits
In many cases, implementing a project depends on obtaining the appropriate licences, permits and concession ns from the host state. It is essential that these permits be made transferable or renewable as the case may dictate in order to maintain the on-sale value of the project. The government may negotiate certain clauses which give it the right to revoke the licence or concession. In cases like this, the lender can seek security through government approval of financing of the project. Negotiations in respect of operation license, expatriate quotas and approvals should be covered in the concessionary agreement.

International finance project involves cross border transactions in which, case cost and revenues on the same project are computed in different currencies (currency of the financier and the host country). It is therefore instructive for the parties to agree on the currency of transaction, its convertibility, exchange rate and repatriation of profit.[14] The transnational and long-term nature of international project finance makes it almost plausible that the risk of foreign exchange will arise. Generally, parties could negotiate these terms with the host government and include same in the concession agreement.
·        Exchange Rate: After currency has been determined, it is vital to also agree on the rate at which conversion is to be done from the foreign currency to the host state currency and include these terms in the loan agreement between the Lender and Project Company.
·        Exchange Controls – The parties should examine the foreign exchange position of the host country and understand the government’s priorities for foreign exchange. This is because shortage of foreign currency may result in the risk that the project company may not be able to convert local currency into foreign currency to repay the loan. This risk may be mitigated by negotiating priority access to foreign exchange or a guarantee of availability with the host country.[15] However, clearance or permit for importation and exportation of fund should be obtained from the Central Bank or board for transfer of fund.
  • Repatriation of profit: The sponsors and lender are particularly interested in ensuring inflow and outflow of cash from the project and that profit realised are extended to deplete the loan sum. It is therefore central to the transaction that the parties are able to transfer fund from the host country effectively and at a convertible currency. The right of the project company to transfer fund and make loan payment should be included in the concessionary agreement. The project company may also open an offshore and local account through which payments can be made smoothly.
1.     Inflation: This risk exists when certain input costs can be subjected to price inflation. In such cases, the project sponsor must be able to pass on these price increases to customers. If the project output is a product whose price levels are fixed by the government, the ability to pass on the cost increase will be limited. Similar risks exist when the inputs are denominated in one currency and the project outputs in another. Thus it is important to identify any such risks and the ability to pass them on to the customers. It is not always possible to increase tariffs particularly in power projects.

This comes at the conceptualization of the project. A thorough examination of the viability of the project is carried out first by the sponsors to determine its sustainability. This will encompass duration of the proposed project, cost implication, profit, location of facility and suitability, technological assistance, permits, environmental impact of the project, supply of materials, market projection, debt service capabilities, etc. An independent feasibility study is later carried out by the lender to supplement the first study. This is to ensure the ‘bankability’ of the project.
Generally, sponsors will want a non-recourse project financing where there is no recourse to the sponsor’s assets for the debt or liabilities of the project company. Non-recourse financing therefore depends purely on the merits of a project rather than the creditworthiness of the project sponsor. The project debt repayment depends on the cash flow sourcing from the revenue generating contracts of the project and the assets of the project are used as collateral for the debt.  In this case, the project sponsor has no direct legal obligation to repay the project debt or make interest payments. The ability to take effective security can assume crucial importance in project finance.[16] In some jurisdictions, laws on the taking and enforcement of security, especially movable assets, cash flows and contractual rights (such as receivables) may not always be satisfactory.[17]
In major international projects, it is highly likely that more than one jurisdiction will be relevant to the security package given to the lenders. Relevant jurisdictions may include where the project is located, where the project company is incorporated, the sponsors and any intermediate holding companies and where the project company's bank accounts are located. Security package can be both onshore and offshore. Security must satisfy any relevant formalities in each relevant jurisdiction.[18] The structure of the loan and interest rate should be agreed upon and included in the loan agreement. Collateral security document should be negotiated separately. Usually, while the language of the loan agreement is in the lenders language, the collateral security document should be in the host state language.  It is important to instruct local counsel in the relevant jurisdictions to confirm that the proposed security package is appropriate and capable of being validly perfected.
Political stability is an important ingredient for cross-border project financing which contributes to the success of the project. This is because the power project is more likely to rely on governmental concessions, tax reliefs, licences or permits.[19] Lenders and sponsors alike are interested in carrying out background check on the political history and regulatory climate of the host government to determine its credibility and stability. Political risks may include the decision by a government to cancel the project or to change the terms of the contract or not to fulfill its obligations, failure to implement the tariff reliefs agreed upon in the contract, the risk of expropriation or nationalization of project assets by the government etc.
Expropriation or naturalization occurs where a host government acquires the rights or assets of a project or where a government measure on the aggregate deprives the sponsors of the equity ownership or value of the investment.[20] The latter is known as indirect expropriation and it occurs more regularly in modern times when for instance, government of the host state may use a combination of taxes and charges to increase its share of profit in the project.[21] However, such anticipated risks can be mitigated by opening an offshore account, through political risk insurance or by inserting in the concession agreements clauses that imposes an obligation on the host state to pay adequate and prompt compensation in case of expropriation. However, not all political risks are likely to be borne by the government.
Of particular importance to international project finance is the mitigation of natural and political risks. Natural risks are force majeure such as floods and earthquakes, civil disturbances and strikes. Power plants are particularly susceptible to force majeure.[22] This boils down to the importance of feasibility study. The project should be assessed in light of such risks to ensure facility pricing and structure is commensurate with the risk profile of the project and downside cash flow analyses are undertaken to assess how much resistance the project structure has to such deviations.[23] Political Risks Insurance usually covers currency non-convertibility, expropriation and political violence. This can be obtained from the Multilateral Investment Guarantee Agency (MIGA), International Financial Corporation (IFC) and Overseas Private Investment Corporation (OPIC) [24] The lender can also seek guarantee from the host government to cover risks of expropriation and availability of foreign exchange.
A cross-border transaction of this magnitude will require the sponsors and lenders to carry out a background check on the other participants to determine their credit worthiness and business credibility- O &M contractor, Fuel supplier, and Technological support.  Due diligence is carried out by experts including the local legal representation, technical advisers, market advisers to determine the robustness of the underlying economics of the project, the stability and transparency of the host country’s political and legal environment, and other risks. The representation and warranty section of the project contracts, including the project loan agreement serve an important role in the project due diligence process. It basically confirms legally, that certain conditions enabling the project to commence are in place. 
[1] B.A (Hons); LL.B (Hons); BL; LL.M (Ife Nigeria); Researcher, University of Pretoria South Africa.
[2] Under Article 1 of the GATS framework, member states are obliged to extend Most Favoured Nation Treatment and National Treatment to investors and investments from other member states.
[3] J Delmon et al International Project Finance and PPPs, A  Legal Guide to Key Growth in Africa (2012) 43
[4] C Dugue Dispute Resolution in International Project Finance Transactions (2000) 1077
[5] UNCTAD Dispute Settlement: Investor State (2011) 14
[6] Dugue (n 4 above) 1071
[7] T Merna et al Financing Infrastructure Projects (2002) 6
[8] A Fight Introduction to Project Finance (2006) 3-4.
[9] H Switala Project Finance and Obtaining Sufficient Funding for the Successful Completion of Your Project SADB 1
[10] Delmon (n 3 above) 15.
[11] P R Wood Principles of International Insolvency (2007) 3
[12] L Wolff The Law of Cross Border Business Transactions- Principles Concepts and Skills (2013) 35
[13] S L Hoffman The Law and Business of International Project Finance (2008) 50
[14] Hoffman (n 13 above) 41.
[15] ibid
[16] Fight (n 8 above) 58
[17] Ibid
[18] Key formalities include -requirements as to the form of the security or any execution formalities, registration requirements other filing requirements, translation and notarisation requirements and the payment of stamp duties or other fees.
[19] S Gatti Project Finance in Theory and Practice Elsevier (2008) 32
[20] A Stephenson et al Protecting Foreign Investment by Using Bilateral Investment Treaties (2012) 10.
[21] Hoffman (n 13 above) 48.
[22] Fight (n 8 above) 62.
[23] Ibid
[24] Hoffman (n 13 above) 41

Editor's note: This article was originally posted by the author on 9th April, 2016 on www.linkedin.com