Description
In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss (or impact) and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled in descending order.
Singapore & Comparative Law 2 SJICL Journal of International Risk Management and Credit (1998) 2 pp 37 – 75
Support in Project Finance
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RISK MANAGEMENT AND CREDIT SUPPORT IN PROJECT FINANCE
This article surveys risk planning in project finance and the role of the law in facilitating the process of risk spreading and risk reduction. As project finance typically involves an initial high cost-high risk construction and development period followed by a long capital recoupment period, the risks which attend a project should be identified and planned for as comprehensively as possible. These include the legal risks pertaining to obtaining collateral from projects in unfamiliar legal systems. Additional credit support may be required before lenders are willing to participate. In this article, the more common risks are identified and discussed along with the additional credit support that may be necessary to structure a successful finance package.
A. INTRODUCTION 1. What is Project Finance? Project finance is the term applied to a variety of financing structures that have a few features in common. In a project finance, loans for the project are made on a non-recourse or limited recourse basis. Whereas lenders normally assess a loan proposition based the credit-worthiness of the borrower reflected by his asset portfolio and aggregate earning capacity, the lender in a project finance is willing to look primarily to the expected income stream of the project for his repayment. If the project fails or the expected income stream fails to materialize, the liability for repayment of the loan does not pass to the project sponsors and operators – except to the extent expressly assumed by them. Another feature of project finance is the nature of the security package. In contrast to many long term commercial loans which tend to be fully collateralized, the underlying assets which form the collateral for project loans typically do not cover the full amount of the loan. The ability of project lenders to recoup the advancements and interest thereon thus depend substantially on the performance of the project. This accounts for another characteristic of project finance – project lenders scrutinise closely the feasibility studies prepared for the project. This typically involves assessing the technical aspects of the project as well as its economic projections. For undertaking the increased risks of a project finance and incurring the added cost of studying the loan proposals, project lenders charge a higher
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interest rate. Nonetheless lenders who are asked to look primarily (if not wholly) to the future revenues of the project for repayment must be confident of the stability of the income stream. The character of his financing must be in the nature of a lending risk rather than an equity risk. Where the steadiness of the income stream is in doubt, the project may not be a bankable proposition. Additional credit support may be necessary to assure lenders of the base levels of recovery they can expect. Guarantees and performance bonds, in addition to providing that assurance, serve to signal to the lenders the commitment of the parties providing the credit support. Insurance assures lenders that the covered contingencies will not permanently cripple the project. The adept use of credit enhancement devices thus makes the difference between a bankable proposition and one that is not. 2. Attractions of Project Finance The attractions of project finance lie in its features. Project finance packages risks associated with the project into discrete “bundles”. The segregated risks can then be parcelled out to diverse willing parties. It thus allows for parties best able to control or insure against the risks to assume them – it enables efficient risk allocation.1 Splitting up the assumption of project risks in this manner has – in addition to risk spreading – the effect of reducing the associated risks. As a consequence, a project which is unacceptably risky to one party becomes feasible through first, risk spreading and second, risk reduction.
1
This underpins the The Abrahamson Principles formulated in the context of construction contracts: A party to a contract should bear a risk where: 1. The risk is within the party’s control 2. The party can transfer the risk (eg, by insurance), and it is most economically beneficial to deal with the risk in this fashion 3. The preponderant economic benefit of controlling the risk lies with the party in question 4. To place the risk upon the party in question is in the interests of efficiency including planning, incentive and innovation efficiency 5. If the risk eventuates, the loss falls on that party in the first instance and it is not practicable, or there is no reason under the above principles, to cause expense and uncertainty by attempting to transfer the loss to another. “No Dispute – Strategies for Improvement in the Australian Building and Construction Industry” May 1990. A Report by NPWC/NBCC Joint Working Party p 6 cited in Peter Megens, “Construction Risk and Project Finance – Risk Allocation as Viewed by Contractors and Financiers” (1997) 14 ICLR 5 at 8.
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For the project sponsor, project finance enables him to insulate project risks from his portfolio of investments.2 He avoids the risk of bankruptcy from the failure of one project. Although he may be required to provide guarantees as credit support, the guarantee amount may be limited to a level he is comfortable with. Moreover the impact of a guarantee on his balance sheet is less damaging compared to a direct loan even though the extent of liability is the same. Due probably to market inefficiency, the guarantee which is reflected as a footnote to the balance sheet tends to be viewed less unfavourably than a loan reflected directly on the balance sheet. Indeed other credit enhancement devices like take-or-pay contracts may not even be reflected on the balance sheet. Such off balance sheet financing can be extremely attractive to project sponsors as it enables them to avoid the restrictions on borrowing and creation of security interests found in their constitutional documents or existing credit facilities. Project financing assumes increasing importance today as developing economies seek to develop their infrastructure. Infrastructural projects are invariably capital intensive ventures. Financial constraints may hinder a country’s ability to commit its financial resources for the development of its infrastructure. Project financing offers the prospect of private investment in its infrastructural development. Private funding preserves the public coffers. Corollary to this, the participation of private enterprises offers the benefits of commercial discipline. Project feasibility is assessed and undertaken on a commercial basis. If run as a public sector project, considerations like obtaining a reasonable return may not be politically acceptable as the public may view the service to be integral to the functions of a
2
This is usually achieved by incorporating a limited liability company as the special purpose vehicle (SPV) for undertaking the project. Regulators recognise the importance of limited liability companies to capital formation as well as to the encouragement of high risk ventures with potentially high payoffs. For this reason, developing economies have embraced the concept of limited liability companies in their corporations codes. Such is the importance of preserving the sanctity of limited liability companies that common law courts have admitted few exceptions to it. Courts have occasionally disregarded the separate legal personality of the corporation and permitted its liability to pass to its corporators; these invariably involve the employment of the corporate form as a device for fraud. It is however clear that fraud is not constituted by showing that a risky venture is under-capitalised. See Adams v Cape Industries plc [1990] 2 WLR 657 esp 760E (CA); “The Skaw Prince” [1994] 3 SLR 379 (High Court, Singapore). It is possible to obtain non-recourse financing by an express commitment on the part of lenders to look only to the cash-flow generated by the project for repayment of the loans. This manner of structuring non-recourse financing, however, entails careful drafting of the lenders’ non-recourse covenants and is consequently a more costly and less efficient device for achieving the same purpose. Limited liability companies are therefore convenient “off the shelf” devices by which to isolate the risks of a venture.
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government. Private sector participation also permits the employment of efficiency-oriented management techniques which may not be politically acceptable if the project were run as a purely public sector project; for example, a commercial enterprise is able to hire and fire with far fewer constraints than the civil service or statutory body. Permitting the project to be run by commercial enterprises allows a certain insulation from the political factors that inhibit the efficiency of public sector projects. The government continues to exercise its role as the custodian of public interest by setting the terms of the concession and giving the appropriate regulatory responses to unanticipated and deleterious effects of a project.3 The attractions of project finance, therefore, account for the increasing use of BOT and its variants in developing countries.4 The importance of project finance to States is not confined to infrastructural projects. Project finance concepts and structures are also integral to structuring the projects involving concessions granted by governments to exploit its natural resources.5 3. Overview of Article The touchstones of project finance are cash flow and risk analysis. Cash flow is the life-blood of the project. Risk analysis looks at the events which determine whether or not the actual cash-flow falls short of the projected
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From the perspective of the project sponsor and operator, the close identification of the project with a public good presents the risk of political populism: see Section B(4)(v). BOT stands for “build, operate and transfer” or “build, own and transfer”. The premise is that the private company will undertake the finance and development of the project and be permitted to recoup a reasonable return for a specified period before handing over the infrastructure to the state. The variants of BOT include: BOO (build, operate and own); BOR (build, operate and renewal of concession); BOOT (build own operate and transfer); BLT (build lease transfer); BRT (build rent transfer); BT (build and transfer); BTO (build transfer and operate); DBFO (design build finance and operate); DCMF (design, construct, manage and finance); MOT (modernize, own/operate and transfer); ROO (rehabilitate own and operate); ROT (rehabilitate own and transfer). The United Nations Industrial Development Organization (UNIDO) has published an extremely useful book on the subject: see UNIDO BOT Guidelines (1996, UNIDO, Vienna). The book on project finance published by Clifford Chance draws heavily from its experiences as counsel in North Sea oil concessions. See Clifford Chance, Project Finance (1991, IFR Publishing, London).
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cash flow. An appreciation of the risk factors is essential to a realistic assessment of the chances of realising the projected cash flow. This paper examines project risks, primarily from the perspective of the lender. In Part B, I will identify the different risks found over the life of the project and discuss how the risks are managed through risk-spreading and risk-minimization techniques. From the perspective of the lender, risk-spreading or risk-minimisation is credit support since any lowering of lending risk acts as credit support for the project and increases the bankability of the loan proposition. In order to ensure that their lending risk does not deteriorate into an equity risk, lenders require credit support from project participants to secure a minimum level of recovery. Part C examines four classes of credit support devices: legal guarantees, indirect guarantees (instruments which are not strictly legal guarantees but which perform similar functions), insurance, and “soft” credit support (commitments or actions which though not legally binding have the effect of assuring the lender). Issues involving the taking of security interests over project assets are discussed in Part D. A separate section has been set aside for discussing this means of credit support because its legal issues – especially in the cross-border context – tend to be more complex. In this Part, I will first discuss the motivation for taking security despite the fact that in many projects, the assets have little liquidation value. I will then discuss the issues involving three classes of property over which security interests may be sought: real property, movables and receivables. I will end by summarising the legal risks involved in cross-border project finance. B. RISK FACTORS: IDENTIFICATION AND MANAGEMENT 1. Feasibility Study Fundamental to assessing the bankability of a project is the feasibility study. The non-recourse basis of loans in project finance, as well as the limited recovery that can be expected from the liquidation of project assets, puts high premium on the reliability of the feasibility study. Moreover, unlike established business enterprises which tend to have a certain track record and a certain degree of diversification, the risks associated with a project loan tend to be highly project specific; the lender does not have the benefit of risk-spreading that comes from diversification of a business enterprise’s undertakings. These factors serve to differentiate a project loan from a normal collateralized loan. Whereas lenders of fully collateralized loans can afford to be somewhat more indifferent to the intended use of the loan, project lenders cannot afford to do so. As they derive their returns almost exclusively
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from the cash-flow of the project, they must be confident first, that the project is technically feasible and second, that the project is economically viable.6 (a) Technical feasibility. A project requiring large capital commitment must involve careful and detailed feasibility studies by reputable experts. Every aspect of the project which impacts on its feasibility has to be carefully studied. A plant must be capable of producing what it is intended to produce in the quality and quantities expected. A pipeline project must be capable of carrying the projected throughput. The market studies which form the basis of cost estimates and revenue projections must be realistic. The lender and its agents would conduct a careful study on the project design, the construction schedule, the start-up performance standards to be satisfied prior to handing over of a turn-key project, and of course, an appraisal of the output projections. A borrower who hopes to secure the commitment of lenders must prepare rigorous feasibility studies which address the concerns of the lenders and instill in the lenders confidence in the borrower’s ability to produce the results promised. Lenders generally prefer projects involving tried and tested technology. These are the projects which will produce the steady cash-flow so essential to servicing the debt obligations. Projects which involve new technology and untested innovations are more properly reserved for venture capitalists; after all venture capitalists have the mandate to participate in risky projects which may produce much fruit for its investors. The mandate of commercial lenders is different; their depositors expect the banks to invest the funds entrusted them in “safe” loans. The capital contribution of banks to projects must therefore be fairly “safe” if their mandate is not to be abused. Nevitt indicates that banks which engage in loans with a spread of 300 basis points and above are engaging in speculative ventures which are more in the nature of an equity risk rather than a lending risk.7 That bank failures can have severe repercussions for
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The debt – equity ratio of a typical infrastructure project ranges from 70:30 to 80:20. The high leverage also means that the risks assumed by equity participants is high. A high compensatory rate of return is therefore necessary to attract project sponsors and other equity participants. Depending on the nature of the project, the contractual arrangement and perceived credit-worthiness of the host country, the rate of return required ranges from 18% to 25%. See Jane Walker, “Private Sector Infrastructure Development Funds” in Infrastructure Development in Sri Lanka: Regulation Policy and Finance (Asia Law & Practice, 1997) Chap 10. P Nevitt & F Fabozzi, Project Financing (6th ed, 1995, Euromoney) p 10. The current banking crisis afflicting the Asia-Pacific countries (in particular South Korea, Thailand and Indonesia) underscore the importance of a sound banking system. The literature on bank failures is vast. Some of the more recent ones are: The Causes and Costs of Depository Institution Failures (1995, Kluwer Academic, Boston); Goldstein, Banking Crisis in Emerging
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the state and international economy is well documented;8 regulators therefore impose strict control over the lending policies of banks with consequential impact on their capacity to lend on a non-recourse or limited recourse basis. (b) Economic viability. Closely tied in with the technicial feasiblity of the project is its economic viability. Are the cost estimates overly-optimistic? Do they take into account the contingencies of cost-overruns, currency fluctuations and possible interest rate changes? Lenders must be satisfied that revenues generated by the project are capable of covering operating expenses, debt service obligations, tax liabilities, royalties and other financial obligations. Project finance thus involves a degree of sophistication in credit analysis that extends beyond normal loans. While lenders would engage their own experts to evaluate the feasibility study submitted by the borrower, lenders must be capable of evaluating the technical and financial projections, as well as the assumptions used in the studies. For this reason, banks regularly participating in project finance will have their in-house technical experts who are invariably engineers with a career background in the industry capable of providing their independant evaluation of the feasibility studies. Its creditassessors will also need to be savvy in evaluating marketing projections. Careful scrutiny of the technical feasibility of a project and its economic viability necessarily means that one has to be sensitive to the impact of adverse factors that may assail the project. 2. The Construction and Development Phase The typical profile of an infrastructural project involves a “high cost/ high risk” construction and development period followed by a relatively long “low revenue-low risk” cost recovery period. The construction and development phase constitutes the long gestation period before the project sees any significant revenue stream. Much of the capital required for the project is ploughed in during this period. The unfortunate experience of many projects is one where the required capital outlay escalates into unanticipated
Economies: Origins and Policy Options (1996, Monetary and Economic Dept, Bank for International Settlements, Basle); Andrew Sheng, Bank Restructuring: Lessons from the 1980s (1996, World Bank, Washington DC). Much ink has been spilled over the savings and loan crisis in the United States. The crisis is particularly interesting for the policy errors and the social consequences of the bank failures. See, eg, Benston, An Analysis of the Causes of Savings and Loan Associations Failures (1985, Saloman Brothers Centre for Study of Financial Institutions, NY); Barth, The Great Savings and Loan Debacle (1991, AEI Press, Washington DC); Mayer, The Greatest-ever Bank Robbery: the Collapse of the Savings and Loan Industry (1990, Maxwell Macmillan International, NY).
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(and sometimes unimaginable) proportions. The channel tunnel project, for example, started wth a cost estimate of some £4.7 billion; the total actual cost amounted to above £10 billion.9 A prudent lender will make a careful scrutiny of the assumptions underlying the cost estimates and the estimated period of construction and development stated in the feasibility report. For this reason, potential lenders to Taiwan’s High Speed Rail Project cast a wary eye on the rather optimistic timetable set by the authorities.10 There are a multitude of causes for cost overruns: a devaluation in the currency to be converted resulting in increased cost of imported building material, an embargo against the host country resulting in increased fuel, energy and transportation costs, unexpected legal problems in land acquisition requiring additional expense in litigation or negotiated settlement. A certain measure of control can be exercised over some of these risks.11 Futures contracts and long term supply contracts permit the price of raw materials to be fixed in advance. Risk of currency fluctuation can be hedged through currency swaps. Certainty, however, has its disadvantages. A fixed price for project supplies means that it is unable to take advantage of lower market prices when the market drops. Transaction costs of financial products like swaps will also impact on the profit margin of the project. Delay in the completion of the construction will delay the commencement of revenue-generating operations. The consequences of delay should ideally be borne by the responsible party or alternatively, the party best able to control and minimise the risk.12 As between the lender and the project sponsor, the latter invariably assumes the obligation to ensure that the project progresses as scheduled. This is backed up by the necessary performance bonds, arrangements pertaining to deferral of repayment and capitalisation of further interest payments. The project sponsor will in turn obtain performance bonds from his contractors and sub-contractors in order that the persons having the most control over timely completion of the different project components are made responsible for the consequences of their actions, inactions, oversight or incompetence. It is, however, not always possible to make project contractors
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“A Stormy Passage to Profit” The Economist 30/4/94. “More money down the hole” The Economist 16/10/93. 10 The concession contract was to be awarded by June 1997, land acquisition completed by December 1997. The guideway construction was scheduled for July 1997 to June 2002 while the supply and installation of the system was scheduled for July 1999 to December 2002. See Cassingham, Chang & Lee, “Taiwan’s High Speed Rail” in Project and Infrastructure Finance in Asia (2nd ed, 1996), pp 264-274 at 266. 11 See discussion at Part B4(ii). 12 See note 1.
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strictly liable for failing to deliver on time. The delay may be caused by external events beyond the control of parties. While contractors may be willing to bear responsibility for delays attributable to them, they may not be amenable to being strictly liable for delays like civil disturbances and acts of God which are beyond their control. Some of these risks are insurable at reasonable premiums, others are not. Amongst the project participants, the project sponsor is often left as the bearer of residual risks. Some lenders avoid the risks associated with construction and start-up by delaying their participation in the lending syndicate till the commencement of operations. These lenders are only willing to assume the operating risks of a functioning plant. The loan capital required prior to the commencement of operations is provided instead by construction lenders. These are lenders who have more experience in construction lending and are better able to manage the loan over the construction and development phase; they also wish to confine the time horizon of the loan to one which they are comfortable with. Their lending commitment is until the completion of the construction or until the completion of the start-up tests; the termination of their lending risk is secured by a “take-out” commitment from the permanent lenders. For assuming the greater risk associated with the prior phases, the construction lenders are compensated by higher fees and interest charges. The take-out obligation is normally activated by the conclusion of start-up tests demonstrating the attainment of performance specifications found in the construction contract. It is thus important for potential lenders to have the capacity to assess whether the proposed performance specifications are acceptable so that they may negotiate for suitable modifications before the loan package is finalised. Lenders guard against the risk of cost overruns and delays by extracting completion guarantees from the project sponsors and interested parties. The completion guarantee may take the form of an undertaking that the construction will be completed by a specified date coupled with an undertaking to service the interest due on the loan. As an alternative to or in addition to the undertaking to service the debt, the guarantor may undertake to provide such further funds as are necessary to cover cost overruns. Completion guarantors may assume the obligation to “take-out” the lenders should the delay extend beyond a specified period. Indeed the financing at this stage may be de facto full recourse financing. It is axiomatic that a perfectly sound commercial proposition can be ruined by the erroneous choice of contracting parties. The key to actualising the potential of a good project and for the completion guarantor, avoiding liability under a completion guarantee, is the selection of financially responsible and technically competent contractors. The consequences for failing to deliver on time should be clearly spelled out. Liquidated damages clauses
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are usually inserted to avoid the doctrinal and practical difficulties associated with proving damages.13 This should preferably be supplemented by a performance bond issued through a financial institution. The latter can serve as valuable collateral14 and has the advantage of avoiding to a somewhat greater extent the credit risk of the contractor. 3. Start-Up Phase The start-up phase commences with the first operations of the project plant or facility. For the construction of a plant to be considered successful, the plant must function at the projected cost and according to the specifications found in the feasibility study. These form the basis for the cost and revenue projections. Incongruence between the actual cost and the projected cost upsets the cash flow estimates by which the debt is to be serviced. A shortfall in the production capacity impacts on the revenue stream as does the inability to produce products of the requisite quality. The rigor of the start-up tests determines the point at which the risks pass between the participants. For this reason, lenders normally require the plant to be proven to function at the capacity and according to specifications before allowing completion guarantors to be released from their obligations.15 Permanent lenders too will require the project to perform as expected before they “take-out” the construction lenders. If there has been an inadequate evaluation of the criteria and standards adopted for the start-up tests, the
13
Liquidated damages clauses avoid the need for a separate hearing for the assessment of damages. It also has the advantage of avoiding the limiting principles which prevent the aggrieved party from proving and claiming the full extent of his damage. The principles governing remoteness of damage and the doctrine of mitigation are two of the more significant limitations. While a liquidated damages clause will not be upheld if it amounts to a penalty, much leeway is given to parties’ agreement; common law courts are increasingly adopting the view that the liquidated damages clause must be shown to be unconscionable or oppressive before they are considered penalties. See Phillips Hong Kong v AG of Hong Kong (1993) 61 BLR 41 (Privy Council, Hong Kong); AMEV UDC Finance v Austin (1986) 162 CLR 170 (High Court of Australia). 14 See Section C(1). 15 In the case of Super Terminal 1 at Chek Lap Kok Airport (HK), the project was deemed completed by an unusually subjective set of criteria: some combination of (a) certification by the project sponsor (b) inspection to the satisfaction of the lenders’ engineers (c) the Airport Authority’s acceptance of the project sponsor’s certificate. This was necessitated by the impracticability of testing the cargo handling facilities by the objective criteria which would have involved bringing “50 000 tonnes of cargo ... to the site and process(ing) them according to an arbitrary pattern”: R Beales, “Case Study: Hong Kong Air Cargo Terminals Limited – Super Terminal 1” in Project and Infrastructure Finance in Asia (2nd ed, 1996), at 162-63.
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lenders may be left holding what is in effect equity risk as the guarantees lapse before the plant is capable of producing the cash flow necessary to support the debt service obligations. The start-up period is therefore the time for trouble-shooting and problemsolving. The technology adopted may fail to deliver. The design of the facility may be deficient. Machinery invariably need to be tuned repeatedly before targeted performance on a sustained basis is attained. It may take many months of testing and problem-solving before the project reaches the end of the start-up phase. 4. Management of Operational Risks and Risks Common to All Project Phases If a risk profile is drawn over the life of a typical project, the period following start-up – the operational phase – will show a steep decline in the risks associated with the project. The project is in its productive stage. Many of the risks affecting this phase are common to those found in the earlier stages of the project life: currency risks, fluctuation in product and commodity prices, natural disasters, civil disorders and political populism. Many of the risk management techniques that are discussed in this section are therefore applicable also to the previous sections. (i) Fluctuation in the prices of raw materials, fuel and transportation A rise in the price of raw materials, fuel or transportation increases the cost and affects the nett earnings of the project. Long term supply contracts may be considered for fixing the price of items like the raw materials and transportation. A form of long term supply contract which gives added assurance is the supply-or-pay contract; in a supply-or-pay contract, the supplier undertakes to provide the extra cost incurred by the purchaser in procuring the supplies from an alternative source should the supplier fail to deliver. It is therefore a guarantee from the supplier that he will fulfill his promises, failing which he will provide the additional cost of securing alternative supplies. Nevertheless, while long term supply contracts provide the advantage of certainty, they are not without their drawbacks. Suppliers who bear the risk of fluctuation in the price of the contracted supplies have to be adequately compensated for assuming this risk. The price charged will tend to be higher. This causes the enterprise to be less flexible in
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For a more in-depth discussion of this problem, see AC Shapiro & S Titman, “An Integrated Approach to Corporate Risk Management” Midland Corporate Finance Journal 3:41-56 (Summer 1985).
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responding to market changes in the price of the product;16 other more supple manufacturers are able to adjust the price of their products in response to lower cost inputs to an extent that the manufacturer with the long term supply contract cannot. Moreover as suppliers are themselves subject to variable cost items, suitable price escalation clauses may be necessary before they will agree to contract on a long term basis. Some of the risk of price fluctuation is thus shifted back to the project.17 Nonetheless, the advantage of assuring a continuous supply of the production inputs may still commend the long term supply contract. Suppliers to the enterprise may hold a monopoly over the supplies in that locality. The power company managing the local grid may raise its charges after the enterprise has enscounced itself. The transportation company holding a monopoly in the area may extort exorbitant rates which seriously shave the margins of the project. Long term supply contracts give a certain assurance that the cost estimates will be kept within predictable bounds. Futures contracts available on the commodities market may also be adopted to hedge against the price fluctuation in certain raw materials. These are, however, short to medium term hedging instruments. Tailor-made forward contracts may be needed if one wishes to hedge against price fluctuation of an input to be acquired in the more distant future.18 (ii) Financial risk: currency and interest rate fluctuation19 Currency and interest rate risks are not unique to the operational phase. They affect the cost items in the construction and development phase as
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Whether the risk is shifted wholly or partially back to the enterprise is of course dependent on the formula adopted in the price escalation clause. 18 “Futures” and “Forwards” both refer to contracts where the obligation to perform is in the future but the price paid is fixed at the time of contract. The difference between a futures contract and a forward contract is that the former is traded on exchanges whereas the latter is tailor-made to suit the needs of the particular client. They can relate to commodities like pork bellies and coffee, or financial products like currency and interest rate. See below. 19 Futures, forwards, options and swaps are collectively termed derivative instruments. This is because the value of each of these instruments is derived from the underlying security. As stated in the text, they are useful for managing risks and financial planning. Nonetheless they are also “side-bets” on the value of the underlying asset and if abused, become instruments for gambling. See Lillian Chew, Managing derivative risks: the Use and Abuse of Leverage (1996, Wiley, Chichester, NY). For some financial texts which give more general treatment of the subject matter, see David Winston, Financial Derivatives: Hedging with Futures, Forwards, Options and Swaps (1995, Chapman & Hill, London); Erik Banks, Complex Derivatives: Understanding and Managing the Risks of Exotic Options, Complex Swaps, Warrants and Other Synthetic Derivatives (1994, Probus Publishing Co, Chicago).
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they do the cost items in the operational phase. An appreciation of the Yen against the US dollar increases the price of the imports from Japan if the denominated currency for the loans and financial projections is the US dollar. The revenue stream from a power supply contract fixed in Rupees will suffer a devaluation when the Rupee depreciates against the currency in which the loan is denominated. Currency risks may be hedged in a number of ways. Currency futures contracts enable the entity at risk to fix in advance the conversion rate between currencies for a stipulated date. Another hedging device is the currency swap. In a currency swap, one party expecting a cashflow denominated in a particular currency (say Singapore $) enters into a binding contract to exchange it for a stipulated amount of another currency (say US$). This enables the party owing debt obligations in US dollars to secure the cash inflow in US Dollars even though its receipts and revenues are in Singapore dollars. A third hedging device is a multi-currency loan. If a loan consists of a basket of currencies, the fluctuation amongst the different currencies may offset against one another. However, hedging the currency in which the revenue is denominated against the basket of currencies is also a much more complicated affair. Borrowers in loans made on a floating rate basis run the risk of interest rates rising to their detriment. One way of hedging against this risk is to enter into an interest rate swap: one party swaps his floating rate risks for the fixed rate risks of another party. Should the interest rate rise above a particular level, the party who formerly held the floating rate interest risk is now assured that the difference in interest payments will be made up by supplementary payments from the counter-party to the swap.20
Erik Banks also has an informative book on the Asia-Pacific market: Asia Pacific Derivative Markets (1996, Macmillan Press, Basingstoke, Hants). Accounting practice and regulators are struggling to keep up with the pace of financial innovation. For recent literature, see Managing the Disclosure Risks of Investing in Derivatives (Meredith Brown ed, 1996, Kluwer Law International, London); Hudson, The Law on Financial Derivatives (1996, Sweet & Maxwell); Bettelheim Parry & Rees, Swaps and Off-Exchange Derivative Trading: Law & Regulation (1996, FT Law and Tax, London). 20 For a good concise overview, see Nevitt & Fabozzi, Project Financing supra, note 7, Ch 24. For a more detailed description, see Satyajit Das, Swap and Financial Derivatives: The Global Reference to Products, Pricing, Application and Markets (2nd ed, 1994, Law Book Co). For sample documentation, see Gooch & Klein, Documentation for Derivatives: Annotated Sample Agreements and Confirmation for Swaps and Other Over-The-Counter Transactions (3rd ed, 1993, Euromoney). Also Gooch & Klein, Documentation for Derivatives: Credit Support Supplement. Annotated sample credit support provisions for over-the-counter derivative transactions (1994, Euromoney).
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(iii) Changes in market demand and market price Financial projections used in the feasibility studies may go seriously offmark when the market price of the project product or service is vulnerable to fluctuation. Competition from manufacturers of like or alternative products may significantly diminish the market share held by the project. Competitors who offer better products may undermine the demand for the project product. In the worst case scenario, a collapse in the market for the product or service offered by the project will also mean the drying up of revenue and hence the cash flow to the project. There is also the danger of technological obsolescence. After devoting substantial resources to the development of a plant based on a particular technology, the project participants may find that technological advancement has made their plant uneconomical compared to their competitors. The market survey providing the basis for the recommendation in the feasibility study has to be realistic in its estimation of the anticipated volume and price of the product or service. Internal market studies are not infrequently required to be backed up by the reports of independent marketing consultants. The assurance that they provide comes in the form of the damage to their reputational capital should their opinion fail to be sufficiently circumspect; there is also the prospect of legal liability for negligent misstatements. Projects which are ideal for project financing are those with predictable and stable cash flow patterns. Highway projects, power generation plants and high speed rail fall into this category. The nature of the projects ensures a certain hold on the market for the product or service offered. The driver who does not wish to pay the toll for a highway may have the option of travelling along the old trunk road; but the savings in time and convenience offered by the highway will cause him to use the highway for long distance travel. An internal rate of return21 sufficiently attractive to attract project sponsors and lenders is invariably worked into the concession granted by the relevant government authority. With good government support and natural monopoly afforded by the nature of the project, the returns to the
21
Defined as the discount rate at which the net present value (NPV) of the project becomes zero. The constraints of space do not admit elaboration of NPV and the internal rate of return (IRR). A more detailed explanation can be found in any basic finance text. See, eg, Brealey & Myers, Principles of Corporate Finance (5th ed, 1996, McGraw Hill) Chap 3 and 5. 22 Government support has been crucial for the profitability of UEM, the company having the controlling shares in PLUS, the company managing the North-South Highway in Malaysia. Despite protests by consumer groups, the Malaysian Government permitted a toll
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equity contributors and lenders are assured.22 Another way which projects can be insulated from movements in the market price of its products or services is to enter into a long term contract with potential output purchasers. The value of such contract is further discussed in Section C(2). (iv) Disruption of Operations A variety of unwelcome events can potentially disrupt the operations of a project. Fires, civil disorders, natural disasters are but a few examples. Where insurance is obtainable, lenders will normally insist that adequate insurance be obtained. Otherwise, the project may find itself short of funds to repair the damage. Lenders may then be compelled to advance further sums in order to have the chance of obtaining the recoupment of the principal advanced. Events beyond the control of the parties may intervene which under the general law governing the contract excuse the parties from the performance of their obligations. This is covered in English law by the doctrine of frustration and in France law by the doctrine of force majeure. Contractors
increase of 3.74 sen a kilometre on the original rate of 7.5 sen a kilometre over a 3 year period from September 1996. The profits of UEM jumped 90 per cent from M$269.6 million to M$513.2 million between 1995 and 1996. “UEM profit nearly doubles thanks to tollroad firm” Business Times (Singapore) 21/03/97. Indeed the Malaysian Government has indicated that if the concessionaries are asked to widen the highway and to provide additional facilities, the concession may be extended by another 17 years from the 23 years now remaining under the original concession: see “Tolls to remain on Malaysian Roads for 40 more years” Asia Pulse 27/5/97. One analyst described the project as “sustainable, recessionproof toll-based earnings”: see “Malaysia’s UEM to ring in higher net profit for 1996 ...” Agence France-Presse International 14/3/97. Indeed, such is the profitability of UEM that it has secured a short term rating of P1 and a long term rating of AA2 by the Ratings Agency Malaysia (RAM): “Ratings of Malaysian Highway Builder PLUS Bhd Reaffirmed” Asia Pulse 22/5/97. The Super Terminal 1 project at Hong Kong’s Chek Lap Kok Airport is more exposed to market forces. The volume of cargo passing through and the pricing of charges is subject to competition from regional airports as well as the smaller facility run by Asia Airfreight Terminal Company Limited. If there is any natural monopoly, it consists of only the cargo necessarily passing through Hong Kong Airport and the limited capacity of the competing cargo facility. (Super Terminal 1 has a capacity of 2.6 million tonnes per annum compared to the competitor’s 400,000 tonnes per annum.) The growth in cargo volume passing through Hong Kong and the track record of HACTL (the project sponsor and operator) were causes for confidence in the viability of the project. The willingness of lenders to commit to the loan package demonstrated the confidence in the future of Hong Kong Airport as well as confidence in competitiveness of project sponsor/operator, HACTL. See R Beales, supra, note 15.
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may consequently be under no obligation to perform and thus suffer no liability for failing to do so. Project participants may leave the risk allocation to the general law but it is preferable to define the circumstances under which a party is excused and the consequences therefrom.23 (v) Political Risk The government hosting the project has an interest in regulating the manner in which the project carries out its activities. If the project emits noxious fumes or releases toxic effluents into the rivers, the government in fulfilment of its duty to its populace should impose suitable sanctions. In an extreme case, the operating permit of the project should be terminated. However, politicians do not always act rationally or in a principled manner. Licenses may be revoked for reasons of political expediency. Foreign interests are particularly susceptible to political populism.24 Local business interests may stir up a public outcry against the award of contracts to foreigners who are objectively more competent and offer a more reliable track record. The jealousy that comes with the profits from the local economy to a foreign project sponsor often blinds the eyes of the detractors from the benefits contributed to the local economy by the project sponsor. Expropriation is often identified with nationalism in newly independent countries in the post-colonial era. In efforts to shake off the dominance of foreign enterprises over the local economy, foreign enterprises were nationalised. The tide of expropriation has subsided with the realisation that carefully chosen foreign investments can develop the local economy.25
23 24
See further discussion of this in the context of security over receivables in Part D(2)(c). A recent example is that of the Enron power project at Dabhol, Maharashtra in 1995. Doubts over the fairness of the deal precipitated the public outcry which led to a subsequent revision of the deal by the new state government. (The parties constituting the new state government, pursuant to its election platform, originally intended to cancel the project but relented after subsequent negotiations proved fruitful.) See Bibek Debroy, “Reforming the Power Sector – An Indian Perspective” in Infrastructure Development in Sri Lanka: Regulation Policy and Finance (Asia Law & Practice, 1997) Chap 8. 25 The increasingly liberal climate is reflected in the different national investment codes and multilateral investment codes. For a survey, see Ibrahim Shihata, “Problems relating to Entry of Foreign Direct Investment” in Current Legal Issues in the Internationalization of Business Enterprises (LH Lye et al ed, 1996, Butterworths, Singapore). 26 Studies show that the incidences of indirect expropriation has overtaken the incidences of direct expropriation. See, eg, Minor, Developing Countries and Multinational Corporations: Why Has the Expropriation Option Fallen from Favour (1986). 27 The dispute which went for arbitration before the ICSID tribunal resulted in a series of awards which are found at (1992) 89 ILR 366-662. For comment on the arbitration awards, see M Sornarajah, “ICSID Involvement in Asian Foreign Investment Disputes: The AMCO and AAPL” Cases (1995) 4 AsYIL 69.
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Nonetheless, the spectre of expropriation persists.26 In Amco v Indonesia,27 Amco (Asia) entered into a joint venture with Wisma Kartika, an Indonesian corporation controlled by an army pension fund. The venture was to build a hotel complex located in Jakarta – the Kartika Plaza. When the dispute between the joint venturers proved intractable, Wisma with the assistance of the Indonesian armed forces occupied the plaza and took over the project. While the de facto expropriation of Amco’s share in the venture by a quasigovernment body did finally end with the award of compensation to Amco, the arbitration process was arduous and the result by no means assured. Foreign participants often co-opt locals who are positioned to provide the political buffer against influences that would otherwise assail the project. A project consisting of both foreign and local participants is less susceptible to political mood swings against foreigners. Local participants with good connections are also better able to liaise and negotiate with the host government. However, as the Amco case shows, local participation also entails the danger that the local participant may turn against the foreigner. Adverse political action may also assume the form of increase in import and export tariffs or increase in income and capital taxes. Although the consensus of economists is that trade liberisation and the lowering of trade barriers generally benefits the development of a country,28 import and export tariffs are a convenient source of revenue. They may also be invoked for a variety of reasons. The desire to nurture infant domestic enterprises and the imperative of preserving the indigenous culture are but two of the reasons commonly cited. Income and capital taxes may be raised or lowered according to the fiscal policy of the nation; this, in turn, is a function of the economic circumstances of the country and its competitiveness vis-à-vis its competitors. As government policy evolves to meet changing circumstances, tax advantages may be cancelled and preferential quotas and tariffs removed. A means of reducing the exposure to the caprices of national politics is the use of an international consortium of lenders. A host country is less likely to embark on actions which adversely impact on a project and its lenders if the lenders are from capital exporting countries on whose goodwill the host country depends. A further way to bolster the project is to involve international lending agencies like the World Bank, the Asian Development Bank and other regional development banks. The project loan package is structured such that a default on the commercial loan results in a default on the loans from these international agencies. Cross-default clauses may be used to link the commercial loan to the loans made by these agencies.
28
For an excellent account of the historical development of trade theories, see Douglas A Irwin, Against the Tide: An Intellectual History of Free Trade (1996, Princeton University Press).
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An event of default will result in cross-default in a number of loans, resulting in a lowering of the country’s credit rating. Even the best intentions of a government may be overwhelmed by changes in circumstances. A government which has offered assurances about convertibility of local currency into foreign currency may suddenly be confronted with an economic crisis which necessitates the revocation of its prior promises. Civil disorders, insurrections and civil wars may overcome the ability of the government to protect the investments in the project. To encourage foreign investment in developing countries, the World Bank has set up the Multilateral Investment Guarantee Agency (MIGA) to provide insurance unavailable from commercial insurers. The terms of the Convention setting up of the MIGA provide for four broad areas of risk coverage: (i) currency transfer risk;29 (ii) expropriation risk;30 (iii) breach of contract31 and; (iv) war and civil disturbance risk.32
29
Art 11(a) (i) MIGA Convention: “ ... any introduction attributable to the host government of restrictions on the transfer outside the host country of its currency into a freely usable currency or another currency acceptable to the holder of the guarantee.” The insurable risk extends beyond explicit refusal of the application to convert the currency to undue delays to act on the request: Operational Regulations of the Multilateral Investment Guarantee Agency para 1.24. 30 Art 11(a)(ii) MIGA Convention: “... any legislative action or administrative action or omission attributable to the host government which has the effect of depriving the holder of a guarantee of his ownership or control of, or a substantial benefit from, his investment ...” The terms were drafted widely to recognise that expropriation can be direct (eg, nationalisation) as well as indirect (eg, revocation of license, change in regulations to require increased local equity participation). The coverage, however, does not extend to “nondiscriminatory measures of general application which governments normally take for the purpose regulating economic activity in their territories”: Art 11(a)(ii). General increase in taxes and tariffs which are not aimed specifically at the project would not be covered: see Regulations para 1.36. However, insurance coverage does extend to “creeping” expropriation, ie, the host government imposes a series of measures in which each measure if taken separately is ostensibly in exercise of the government’s legitimate right to regulate the business activities within its territory but which when taken cumulatively has the effect of expropriating the investment. See Shihata, Multilateral Investment Guarantee Agency and Foreign Investment (1988, Martinus Nijhoff) pp 124-131. 31 Art 11(a)(iii) MIGA Convention: “... any repudiation by the host government of a contract with the holder of a guarantee, when (a) the holder of a guarantee does not have recourse to a judicial or arbitral forum to determine the claim of repudiation or breach, or (b) a decision by such forum is not rendered within such reasonable period of time as shall be prescribed in the contracts of guarantee pursuant to the Agency’s regulations, or (c) such a decision cannot be enforced.” 32 Art 11(a)(iv) MIGA Convention: “... any military action or civil disturbance in any territory of the host country ...”
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The protection provided by MIGA extends in many respects beyond the coverage provided by national investment guarantee agencies. For example, national investment guarantee agencies normally treat breach of contract as an expropriation risk and defines the risk coverage in an accordingly restrictive manner. MIGA’s coverage of contractual breach is far wider and includes undertakings given under a stabilisation clause. While expropriation risk insurance coverage does not include regulatory measures of general impact not specifically targetted at the investment, the breach of contract guarantee extends to these measures as long as the host country has given to the project sponsor specific undertakings regarding say, preferential tax rates or export quota. The guarantee scheme is available only to developing member countries.33 Before the contract of guarantee is concluded, MIGA requires the host country to add its approval; amongst other things, this aids the recoupment of its payouts from the host country when adverse events are attributable to the host country.34 It is noteworthy that apart from war and civil disturbance risks, the other risks are largely within the control of the host government. To project sponsors and lenders, international agencies like ICSID35 (which arbitrated the Amco dispute), the World Bank and MIGA help to stabilise the project environment and act as restraints against potentially capricious actions on the part of host governments. They therefore have the function of lowering the political risk and in the case of MIGA, of assisting project participants by taking some risk off them. C. CREDIT SUPPORT AND ENHANCEMENT Project finance is typically highly leveraged. In infrastructural projects, the typical debt-equity ratio is about 70:30; indeed debt-equity ratios of 80:20 are not uncommon. Without credit support and credit enhancement devices, the consequences of project failure would fall heavily on the lenders. The concentration of risks upon the lenders often makes financing on a totally non-recourse basis an unbankable proposition. It is thus unrealistic to expect
33 34
Art 14 MIGA Convention. The Agency is under an obligation to recoup its guarantee payout. Art 18(a) of the Convention establishes the basis under International Law for guarantor agency to be subrogated to the rights of the insured so that it may proceed against the host country for recoupment of its payout. 35 The International Centre for Settlement of Investment Disputes. See further, Convention on the Settlement of Investment Disputes: Analysis of Documents concerning the Origin and Formulation of the Convention (1970, ICSID, Washington).
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lenders to look to the project cashflow as the exclusive source for repayment of the loans advanced. While lenders in project finance accept an increased level of risk compared to fully collateralized loans, they must be assured that their contribution to the capital requirements of the project remains a lending risk. In the event of cost overruns, the lenders should not be found trapped and practically compelled to advance additional loans; there should be a firm and preferably a legally binding commitment on the part of the project sponsors (or other third parties) to infuse fresh capital in the event of such a contingency. If the plant is consumed by fire, there should be found insurance which provide the funds for reconstruction of the plant. Structuring an acceptable project finance thus involves devising an acceptable distribution of risks amongst the various interested parties. This section discusses the various risks spreading techniques that may be adopted in a project finance. 1. Guarantees Guarantees are binding commitments on the part of the guarantor to answer for default in the performance of specified obligations. Guarantees can take many forms. The most basic form assures the lender that the guarantor would pay up on the indebtedness of the borrower should the borrower fail to pay. Performance bonds are a form of guarantee – they are issued by or on behalf of a contractor assuring satisfactory performance of his obligations. The construction contractor or equipment supplier may issue a guarantee covering the timely performance of his obligations. For added security, the beneficiary requests for the guarantee to be issued by a bank. As the nature and extent of a guarantee can be tailored to suit the risk preference of individual guarantors, they are very flexible instruments for risk-spreading. The guarantor may issue an unlimited guarantee for the loans disbursed by the guarantor. Alternatively, he may issue a partial guarantee covering only a stated percentage of the loan. If there is no one guarantor who is willing to assume liability for the entire amount, a few guarantors may be found each of whom will assume a stated proportion of the debt owing; the liability assumed by the individual guarantors will thus be several, not joint and several. Guarantees enable additional credit support to be provided where there is a shortfall in the underlying collateral. Thus for projects located in economies where market conditions and the legal infrastructural limit the realisable value of the collateral, project lenders typically require the project sponsor’s head office to guarantee the loans advanced to the Special Purpose Vehicle (SPV) undertaking the project. Guarantees permit project risks to be shared by persons other than the borrower who are interested in the project and who find it in their interest
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to give guarantees to the lenders. One such class of persons are the suppliers. Project suppliers may be willing to issue guarantees to an extent that is commensurate with their interest in the supply contract. Suppliers of manufacturing equipment will probably be amenable to issuing guarantees covering the performance of the equipment supplied. Where the contract is an especially lucrative one, they may even be persuaded to guarantee certain debts of the customer. Similarly potential suppliers of manufacturing inputs to the completed project may be willing to guarantee part of the indebtedness of the project to secure future orders. Output purchasers who have an especial interest in the product of the project may also be amenable to guaranteeing the debts of the project. A manufacturing facility which appreciates the importance of an adequate power grid may even be keen to add his guarantee to ensure the success of the proposed power plant; indeed, his participation in the success of the power plant may earn him special concessionary rates or preference in the allocation of the resource. In the field of petroleum extraction, petroleum companies who are interested in the project pipeline may – in addition to their obligations under the throughput contract – be expected to guarantee the debts of the SPV constructing the pipeline. As a guarantee is a personal instrument given by the guarantor, it is only as good as the credit-worthiness of the guarantor. While a lender will have little hesitation in taking a guarantee from a company in a strong financial position, they will attach little value to one which is issued by a company which does not have a strong asset base. For this reason, lenders often require the guarantee to be issued by a financial institution. The project sponsor or operator who seeks a guarantee from the supplier of goods pertaining to the reliability or quality of the goods – a performance bond – would also require it to be issued through a financial institution. The intervention of the financial institution is assuring for a few reasons. As a financial institution trades on its reputation, it is unlikely to dishonour its promise. The beneficiary of the guarantee thus avoids the risk of the performing party disputing the validity and enforceability of the guarantee; the unwelcome prospect of enforcing the guarantee through litigation is thus avoided. This consideration is especially important when the performing party is located in a jurisdiction with poor legal infrastructure. Another reason for the attractiveness of the performance bond issued by a financial institution is the fact that the financial institution invariably deals only in documents
36
The autonomy of the performance bond from the underlying transaction is a fundamental principle in banking law. See Bocotra Construction v AG (No 2) [1995] 2 SLR 733 (CA, Singapore); Edward Owen Engineering Ltd v Barclays Bank International Ltd [1978] QB 146 (CA). Also Art 2(b) ICC Rules for Demand Guarantees (ICC Publication No 458) (1992,
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and does not concern itself with the underlying breach.36 The consequence is that the bond must either be unconditional, ie, on demand, or conditional upon certification of the breach by specified experts, eg, appointed professional engineers or surveyors. In either case, the beneficiary of the guarantee avoids the moral hazard risk of the performing party. Some infrastructural projects may be of such importance to the economic development of the host country that the host government may add its guarantee to boost the credit of the project. For example, the government may guarantee minimum cash flows, or undertake to meet the cost overruns in the construction of the plant.37 Such guarantees have effects beyond the financial aspects. The participation of the host government is a good indication of the favour with which the project is regarded and the importance which it is accorded; government involvement, whether through direct capital injection or through guarantees, would thus lower the political or sovereign risk associated with the project. Governments other than that of the host country may also add their guarantees. The home government of the equipment exporter may also guarantee the repayment obligations of the project; such may be the imperative of encouraging local exports or enhancing international prestige that the equipment exporter’s home government may be willing to lend its credit to the project. 2. Indirect guarantees: take-or-pay contracts, throughput contracts and tolling contracts. Long term contracts with output purchasers are the source of cashflow by which the lenders may be paid. Take-or-pay contracts, throughput agreements and tolling agreements are in substance guarantees of cashflow for the project. In a take-or-pay contract, the output purchaser commits himself to make periodic payments of specified amounts whether or not the product contracted
ICC Publishing SA, Paris). The common law admits few defences to a call to pay on the bond once the terms upon which the bond may be called are satisfied – the only judicial exception is the “fraud exception”. UK: United City Merchants (Investments) Ltd v Royal Bank of Canada [1983] 1 AC 168. Singapore: Bocotra Construction v AG (No 2), supra. This exception is, however, narrowly construed – fraud must be in the documents presented to the bank. Fraud in the underlying transaction appears immaterial to the question of whether the bank is still required to pay. The autonomy principle thus takes precedence over the “fraud unravels all” principle. See Loke, “Injunctions and Performance Bonds” [1995] SJLS 682. 37 Indeed governmental involvement is in some cases crucial to the willingness of project sponsors to participate. In Philippines, the assumption of market risks and foreign exchange risks by the Philippines Government was crucial to the success of BOT power projects. See “Manila battles against the past” Project and Trade Finance March 1995 pp 26-28.
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for is delivered. His obligation to pay is thus independent of the actual delivery of the product. It is also independent of the quality of the product delivered. The borrower and the lenders are thus assured of funds for servicing the project’s debt obligations.38 The throughput agreement is similar to the take-or-pay contract except that the counter-party is the user of a facility. The most common subject matter for a throughput agreement is a pipeline. The user promises to pass a specified minimum amount of petroleum or gas through the pipeline; he undertakes to make the payment associated with the minimum use whether or not he actually passes the minimum amount through the pipeline. The amount specified is usually pegged to the cash flow necessary to cover the operating cost and the debt service obligations. The tolling agreement is a variation of the throughput agreement. The term is applied to an agreement between a processing facility and its customers who send their raw materials to the facility for processing. In a tolling agreement, the customer promises to send a minimum quantity of material at an agreed rate. The guaranteed payment may take the form of a capacity reservation fee. The strictness to which a purchaser is held to his payment obligation is largely a function of how the obligation is drafted. As a buyer’s obligation to pay is normally construed to be dependant in some way on the seller performing his part of the bargain, the independence of the two obligations must be manifest. While the more developed legal systems give due recognition to contracting parties’ conscious assumption of onerous obligations on the pacta sunt servanda principle, adjudicators in less sophisticated legal systems may subordinate the pacta sunt servanda principle to the perceived need to address the seeming unfairness of the obligation assumed. Parties dealing in less developed legal systems should therefore investigate whether the covenants they normally use have the same effect. Tightly drafted long term contracts which virtually guarantee the cashflow to a project are valuable as collateral. Indeed lenders often insist on such virtual guarantees so that the proceeds may be assigned to them as security for repayment.39 There are a couple of ways by which the benefit of such contracts may be appropriated to the exclusive benefit of lenders. The right to receive payment may be charged or assigned to the lender. If there are
38
See further, P Nevitt & F Fabozzi, Project Financing (6th ed, 1995, Euromoney) pp 276288; Ryan & Fife, Take-Or-Pay Contracts: Alive and Well in California (1987) 19 Urb Law 233; Nolan, Take-Or-Pay Contracts:Are they Necessary for Municipal Project Financing? (1983) 4 Mun Fin J 111. 39 See Section D(2)(c).
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several lenders, the receivables may be assigned to a trustee who opens an account into which the output purchasers are obliged to make payment. The moneys in the account are thus held on trust for the exclusive benefit of the lenders. Such arrangements enable lenders not only to be protected against the uncertainty of future cashflows, they also insulate lenders from the difficulties that attend the project’s insolvency. In an infrastructural project where the government is the purchaser of the output (eg, power generation projects), the government may enter into a long term contract for the supply of the output at a pre-determined price. This effectively guarantees the cash flows to the project. The risk of price fluctuation – and hence the element of market risk – is removed. Whether the government purchaser is willing to assume a payment obligation independent of the product delivery will depend on how keen the government is to see the completion of the project. While such commitments insulate the project from the perils of the market, the market risk is replaced by the political and sovereign risk earlier discussed.40 3. Insurance The value of insurance as credit support is rather self-evident. If the plant is destroyed by an insured event, the insurance proceeds provide the means for reconstruction of the plant – in part if not in whole. While the insurance would be taken out by the Special Purpose Vehicle undertaking the project, lenders not infrequently require that they be beneficiaries of the insurance policies. The lenders usually also negotiate for the discretionary power to use the money for reconstruction and repair, or to credit the insurance moneys against the debt owing. The latter “cashout” option usually signals the demise of the project unless project participants are able to arrange for a fresh injection of funds toward the reconstruction and repair of the damaged plant. The range of commercial insurance available is quite wide. The “allrisk” builder’s insurance covers losses occasioned during the construction phase. It applies to all perils which are not specifically excluded but does not generally extend to losses that arise from the acts attributable to defaults, eg, payment under a liquidated damage clause. Force majeure insurance provides cover against external events which disrupt the operations of the
40
Fortunately, the room for hedging this risk is greater with the advent of MIGA. See Section B(4)(v). The contribution of MIGA as a stabilising force to the project environment is better appreciated if one is mindful of the limited role that international law otherwise plays in protecting investments. On this, see M Sornarajah, The International Law on Foreign Investment (1994, Cambridge University Press).
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project. System performance insurance covers the risk that the technology or the equipment does not perform at the anticipated level. Although not all risks are insurable or insurable at an acceptable premium, the creation of MIGA has reduced somewhat the lacuna left by commercial insurers. The security that insurance provides to the project, however, is not complete. Insurances lapse. It is important for lenders to ensure that premiums are paid and that they are kept informed of events which affect the effectiveness of an insurance. For this reason, lenders sometimes require the insertion of a clause in the insurance contract wherein the insurer undertakes to inform the lenders of events or actions which affect the effectiveness of the insurance coverage. As insurance contracts are contracts uberrmae fide, insurers are entitled to avoid liability for material non-disclosure; lenders therefore bear the risk that an insurance is rendered valueless for the failure on the part of the insured to provide full and frank disclosure of all the material risks. 4. “Soft” credit support Credit support need not necessarily be legally binding commitments. Non legally binding commitments can also be effective devices for risk minimization and risk spreading. The project sponsor’s home office, while chary of assuming further financial liability for the project, may yet be willing to provide such management and technical assistance as are necessary to ensure the success of the project. What is at stake here is the reputational capital of the promisor. The potential damage to the promisor’s reputation and credit standing should the failure of the project be found to be due to the promisor’s failure to honour its promise may be sufficient assurance to the lenders. Other types of such “soft” credit support include allowing the project vehicle to use a name which manifests a close association with the project sponsor. It is sometimes clear from the nature of the credit support that the promisor undertakes no legal liability. Where the project sponsor permits a derivative of its name to be used for the SPV, for example, the company law of most jurisdictions provide for automatic insulation of the liability of the two companies. A commitment on the part of the promisor may be ambiguous as to whether the promisor assumes a legal undertaking or merely a moral commitment. The context and the wording of the commitment will have
41
The facts of Kleinwort Benson Ltd v Malaysian Mining Corp Bhd [1989] 1 WLR 379 are instructive. The defendant was the holding company of MMC Metals Ltd to whom the plaintiff-bank provided a loan facility of some £10 million. During the negotiations leading up to the loan agreement, the plaintiff-bank was unwilling look solely to the credit of MMC Metals but the defendant was unwilling to guarantee the borrowings of MMC Metals Ltd.
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a determinative effect on the construction of the undertaking given.41 It is, however, important to bear in mind that courts presume commercial agreements to have legal effect; the nature of the promisor’s commitment should therefore be clearly stipulated if he does not intend to assume legal liability. I have earlier alluded to the government’s participation in a project as a means of risk reduction. A government which has a reputation for honouring its word can by little gestures provide the extra credit support necessary to convince the lenders that the project is a bankable proposition. In the Hong Kong telecommunication project, the gesture took the form of a brief acknowledgement by the Hong Kong Government that it would take into account the lenders’ concerns before embarking on any course of action affecting the license.42 Indeed that was the only participation or support by the Hong Kong Government in the project. It was found sufficient by the lenders. D. COLLATERAL IN PROJECT FINANCE 1. Motivation for acquiring security interest over the project assets In a project finance, the realisable value of the collateral tends not to cover fully the loans advanced. This is because the assets involved in a
After prolonged negotiations, a compromise was reached. The Defendants issued two letters of comfort which stated, inter alia, that “it is our policy to ensure that the business of [MMC] is at all times in a position to meet its liabilities to you [under the loan facility agreement].” When MMC later became insolvent, the issue arose whether the defendant had assumed a legal liability toward the plaintiff. The judge of first instance, Hirst J, held that the defendants had assumed a legally binding commitment to the plaintiff but the Court of Appeal disagreed. The Court of Appeal construed the comfort letter to manifest only a representation regarding policy of the defendant existing at the time the letter was issued. As there was no misrepresentation of its policy at the point which the representation was made, there was no cause of action in misrepresentation. The limited construction put on the comfort letter by the Court of Appeal continues to cause some controversy: see, eg, Banque Brussels Lambert v Australian National Industries Ltd (1989, unreported. Noted in Tyree 2 JCL 279). The present author’s view is that what swung the balance in favour of the defendant was a combination of both the context in which the comfort letter was given as well as the wording of the comfort letter. Project counsel would do well to keep a detailed record of the negotiations leading up to the final wording of the comfort letter. While the parol evidence rule may limit the use of such records, Kleinwort Benson demonstrates that it is permissible to use the negotiation process to lay the context leading up to the final draft of the letter of comfort. 42 John East, “BOT Projects in Asia: the Concession Agreement and the Allocation of Risks” in Project & Infrastructure Finance in Asia (2nd ed, 1996, Asia Law & Practice Publishing Ltd), pp 41-52 at 43.
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project finance tend to be illiquid and lose their value once the conditions necessary for supporting the cash-flow no longer exist. The pipeline under the sea has little value if there is no oil to put through it. The plant which is unable to manufacture products of sufficiently satisfactory quality is unlikely to fetch a price which appoaches even its cost of construction. The individual capital assets comprising the project finance have a much diminished realisable value when they are detached from the project. Nonetheless having a first priority to call on the assets of a project – albeit assets of insufficient value to cover the loan – is preferable to being an unsecured creditor. Even if the liquidation of the assets does not allow for full recovery of the loan advanced, the secured creditor has priority over the unsecured creditors. They are likely to recover more than if they were to take no security at all. Moreover if the lender’s security interest covers substantially the operating assets of the company, the collateral can be sold off as an operating unit and would fetch a higher price than if the assets were liquidated piecemeal. While such a manner of disposal would also be the aim of the liquidator,the lenders’ ability to do so may be more expeditious;43 the operating unit may therefore be disposed of before its market value drops significantly. The security interest can also be defensive in nature. The lender’s security interest checks the borrower’s ability to dispose of the assets or to grant security in favour of other creditors. Lenders can of course seek to achieve these purposes by the use of a negative pledge clause; however, the negative pledge clause is strictly a personal covenant with the debtor which is not binding on third parties. The right to sue on the breach of covenant avails him little if the debtor is insolvent. There are of course ways to sue the purchaser or lender who takes the property with notice of the negative pledge clause;44 however the practical and doctrinal difficulties associated with prosecuting the suits render them less advantageous (and less convenient) than obtaining a security interest.
43
This is qualified to the extent that the reorganisation regime imposes a moratorium on the enforcement of security interests. In Singapore, the secured creditor, in addition to suffering from the disadvantage of not being able to enforce his security interest, is not entitled to vote on the plan proposed by the judicial manager: r 74 Singapore Companies Regulation (Cap 50, Reg 1). 44 One possible recourse is to sue under the tort of interference with contractual relatons. The dictum of Jenkins LJ in DC Thomson & Co v Deakin [1952] Ch 646 at 690-699 contains the classic statement of the elements of the tort. Another recourse is to sue the purchaser under De Mattos v Gibson (1858) 3 De G & J 276. Note, however, the ambit of De Mattos v Gibson: see Tettenborn, “Covenants, Privity of Contract and the Purchaser of Personal Property” (1982) 41 CLJ 58. See also Cohen-Grabelsky, “Interference with Contractual Relations and Equitable Doctrines” (1982) 45 MLR 241.
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There is another motivation for taking security which is peculiar to banks. The regulatory authorities invariably place a limit on the amount of unsecured loans that a bank can have in its lending portfolio; it may be more advantageous from the bank’s perspective to make a collateralised project loan – albeit one whose realisable value is uncertain – than a straight unsecured loan. 2. Three classes of property (a) Security interest over real property The value of project land as collateral requires little elaboration. In capitalist economies where free alienability of land is a given, the worth of the collateral is largely a function of economic factors. Even then, legal considerations have a definite impact on the value of the land as a collateral. A re-zoning of the land and a change in the use to which the land can be put can have a significant impact on the value of the land. Agricultural land which is approved for industrial use will appreciate in value. Industrial land which is re-zoned as low-rise residential land is likely to fall in value unless there is a very robust housing market. Doctrines governing ‘takings’ and legitimate expectations restrain government actions and help protect the value of the land. Invariably there will be nuances found in the different legal system which impact upon the value of project land as collateral. The restrictions on the state’s competence to acquire land compulsorily are different in Singapore than in the United States or the Philippines. Different standards would also be applied to determine whether compensation is payable and how much is payable to the owner of the land to be acquired. Nonetheless the differences are reasonably comprehensible as the legal framework of these capitalist economies proceed from certain common assumptions. Indeed they are very often derived from familiar legal traditions and use a familiar vocabulary. The above premises which underlie the legal systems of capitalist economies and hence the value of land as collateral may not be found in socialist countries. While many of these countries are increasingly embracing the principles of market economics and undergoing economic liberalisation, the concept of land ownership and free transferability of land remains inimical to the political idealogies of some of these countries. In Vietnam, for example,
45
Article 17 Constitution (1992). See also Art 1 Law on Land (14/7/93) and Art 690 new Civil Code (28/10/95). For comment on the entrenchment of this notion in the legal culture, see HA Tran, “An Assessment of the Vietnamese Land Law and Regulation” (1995) 13 Wisconsin International LJ 585 at 600-01
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the concept of private ownership of land has not taken root despite economic liberalisation. All land continues to be owned by the state.45 Ventures requiring the use of land obtain from the government “land-use rights.” By the grant of land-use rights, the state grants the entrepreneurs license to use the stipulated state land for the purposes specified in the license and for a specified period of time. At one time, there were real question over the legality of mortgaging these land-use rights; this issue has been somewhat resolved by regulations permitting local banks to obtain mortgages.46 While the Vietnamese government has made modifications to the law to allow for transferability of land-use rights, the transfer is invariably subject to approval by both the national government as well as the local government.47 In substance, therefore, there is no free alienability of land. Moreover, the license is tied to the particular use specified in the license. Any variation in the use of the land requires official government sanction.48 Indeed if the terms of the land-use license are violated, the state may revoke it. All these diminish the marketability of the land-use rights. Lenders to projects in countries like Vietnam continue to be most wary of the efficacy of security over land. It is therefore no surprise that these lenders require additional credit support before they are willing to participate in the loan package. Apart from examining the premises which support the value of land as a collateral, a lender taking a security interest over land should be also be careful to comply with the local law pertaining to “perfection” of his security interest. In Singapore and Malaysia, a lender taking mortgage of a company’s registered land needs to register with the relevant land registry49
46
47 48
49 50
Art 7(2) Ordinance on Rights and Obligations of Foreign Individuals and Organizations Leasing Land in Vietnam (14/10/94) Foreign lenders circumvented the problem somewhat by requiring the mortgage to be given to a Vietnamese bank which covenants to hold the benefit of the security for the benefit of the foreign lenders. However with the promulgation of new regulations in 1996, the legality of such a device is put in doubt. See Regulations on Mortgages and Pledges of Assets and Guarantees for Bank Loans (Promulgated with Decision 216-QD-NH1 dated 17/8/96). By Decree No 12-CP, all land use matters are the responsibility of the Provincial People’s Committees and the Vietnamese Party. See, eg, Art 6(2) Regulations on BOT Contracts (23/11/93): “... mortgaged rights and assets [must] continue to be employed in the implementation of the objectives of the project as stipulated in the BOT contract.” Singapore: s 45 Land Titles Act (Cap 157). Malaysia: s 206(1) and 243 National Land Code (Act 56 of 1965). Singapore: s 131(3)(e) Companies Act (Cap 50) Malaysia: s 108(3)(e) Companies Act 1965. The registration requirement applies to land belonging to the company wherever situated.
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as well as the companies registry;50 failure to do so results in his inability to assert his security against the liquidator and other creditors. In Indonesia, the deed necessary for the creation of hypothec has to be executed before a land deed officer.51 A legal issue which continues to cause not a little concern is whether such a deed executed before a notary public in a foreign jurisdiction is sufficient compliance with the requirements of Indonesian law.52 There are other factors which impair the value of real property as security. Squatters and sub-tenants may have occupancy rights which prevent the sale of the land with vacant possession. In Djakarta (Indonesia), for example, postwar regulations confer occupancy rights in buildings constructed before 1960 which severely affect the secured party’s right to sell these buildings with vacant possession.53 The due diligence process should anticipate these problems. (b) Security interest over movables The resale value to purchase price ratio of movables in a project finance varies with the type of asset involved. Raw materials can probably be sold at market value but used equipment tend to lose much of their original value. Used capital assets like manufacturing equipment, power generators and transport equipment, are likely to be sold at only a fraction of their original cost and are unlikely to permit recoupment of the loans advanced for their acquisition. Moreover, there is also normally a discount on the market value of used assets in a forced sale, whether the company is in liquidation or in receivership. Indeed some assets – like power cables and oil pipelines – though physically movable have practically no resale value. In these instances, the taking of security will largely be for defensive purposes. Different legal systems have different regimes for regulating the circumstances in which the security can be asserted against the liquidator and other creditors. Common lawyers term this perfection of the security interest.
51
Indonesian Civil Code ss 1171. The land deed officer is known locally as the “PPAT”. A notary may be a “PPAT”. 52 S Gautama, Indonesian Business Law (1995, Penerbit PT Citra Aditya Bakti, Bandung) pp 573-4. 53 See S Gautama, ibid, p 570.
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“Perfection” requirements safeguard the interests of other creditors. They should not be led to believe that the debtor has more assets than he actually does. They should be warned against prior security interests that the property may be subject to.54 Perfection requirements take the following two principal forms:55 (a) possession (b) registration and filing. Requiring the secured party to obtain possession of the movable property would often mean physical removal of the property out of the hands of the debtor. Other creditors dealing with the debtor are put on inquiry if a piece of property represented to form part of the unencumbered assets of the debtor are in the possession of a third party. They would or should therefore be extra vigilent in taking security interest over that piece of property. The pledge at common law is such a possessory security. However the common law also recognises the concept of constructive possession, ie, the property is legally deemed to be in the possession of a party even though physical control of the property remains in the hands of another. Thus the concept of attornment wherein the person presently having possession of the movable property intimates to the creditor that he holds the property to the creditor’s order forthwith.56 The creditor-pledgee may, without destroying the pledge, take possession of the goods or documents of title and release them to the debtor on a limited license to use the property as his trusteeagent.57 These doctrines permit the creditor to avoid the inconvenience of warehousing the movable property; it also has the advantage of not depriving the debtor of the use of the assets. Such sophistication of legal doctrine may not exist in less developed legal systems.58 Nonetheless each legal system
54
55
56 57 58
This is the raison d’etre of the Torrens system which aim to put place all interests over land on a register. This system originated in South Australia and has been copied in many jurisdictions including Singapore and Malaysia. Another form of perfection is notification. This is found in the common law governing assignment of choses in action. In an assignment of a chose in action (as in a debt), the assignee who does not notify the person against whom the chose is assertable loses his priority as against a subsequent assignee who gives notice. Dearle v Hall (1828) 3 Russ 1. Martin v Reid (1862) 11 CBNS 730; Meyerstein v Barber (1866) LR 2 CP 38; Dublin City Distillery v Doherty [1914] AC 823. North-Western Bank v Poyntes [1895] AC 56. Under Indonesian law, the pledge is destroyed if the goods pass into the possession of the pledgor with the consent of the pledgee. Civil Code Art 1153. Non-possessory security over movables can, however, be obtained by the use of “fiduciary transfer of ownership”. This device derives its existence not from the Civil Code but from Dutch jurisprudence. In fiduciary transfer of ownership, the debtor transfers his ownership rights to the creditor who leases it back to the debtor. No formalities are required. There is no statutory requirement for registration or execution before a notary public. See S Gautama, supra, note 52, at 607614.
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has its nuances and legal incidents associated with possessory security that may defeat the secured party’s expectations. Creditors dealing on the faith of goods in the possession of the debtor or his agents should not be caught unawares of such legal nuances which undermine the confidence that one can place on things in the possession of the debtor and his agents. A more effective means of notifying the world of encumbrances upon an asset is by requiring the registration or filing of the encumbrance. If the asset is substantial and susceptible to unique identification, a system based on registration against the asset is feasible. Alternatively, the registration system may be based on registration against the debtor; a check against the register would reveal to parties intending to deal with the debtor the encumbrances upon his assets and therefore a good view of his credit position. A rational registration system would provide a convenient “one-stop” shop for both registration and checking. That ideal, however, is seldom attained. There may be overlapping registration regimes governing a particular secured transaction, making it necessary for the secured party to register with multiple registries. Moreover, these different registration regimes may prescribe diverse formalities. These are matters which make it imperative for competent local counsel to be engaged. It may be possible, by astute structuring of the transaction, to avoid the registration requirements of a regime. The extent to which this is possible differs between different legal systems. In England, Singapore and Malaysia, purchase money security can be structured as a charge or in the form of title retention; the latter would avoid the registration requirements which the former would attract. Registration may also be avoided by structuring the instalment sale as a leasing transaction. What may in substance be a security interest may be structured in a form which avoids the registration requirements. The dispensation which a legal regime gives for form to prevail over substance depends as much on the particular provisions of the legislation as its jurisprudence and legal culture. A legal system that leans more toward substantive reasoning than formal reasoning will be more willing to penetrate the form to look at the substance.59 In common law countries, fixed and floating charges can be created against a company. Compared to the pledge, a charge is a much more convenient device. The chargor (debtor granting the charge) is entitled to remain in possession of the asset. In charging the asset to the chargee, he appropriates to the chargee the stipulated assets and grants to him rights over the assets in the event that he fails to pay the debt. The chargee’s interest over the
59
See MG Bridge, “Form, Substance and Innovation in Personal Property Security” [1992] JBL 1.
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asset is a proprietary one; it follows the asset even though it is transferred into the hands of a third party. Thus, a donee of a charged asset takes it subject to the interests of the chargee. Only a bona fide purchaser of the legal interest for value without notice takes the asset free of the chargee’s interests. Whether a charge is required to be registered in order to be effective against third parties depends on whether it falls within the provision governing the registration of charges; if it does not, the charge need not be registered. For this reason, a (fixed) charge over an insurance policy is not registrable in England, Australia, Singapore and Malaysia.60 The registration system found in England is not very rational. Neither are those of its offspring found in many of the Commonwealth countries. A rational system like that found in Article 9 of the US Uniform Commercial Code would require the registration of all security interests. Encumbrances upon a debtor’s assets can be checked conveniently. A nearly comprehensive registration regime while going a long way toward protecting the interests of third parties can also be fatally misleading to parties dealing on faith of its transparency without realizing its loopholes.61 Creditors have found the concept of the floating charge – a creation of the common law – an extremely convenient device. In contrast to the fixed charge which requires the chargee’s specific consent before the asset can be dealt with free of the encumbrance, the floating charge permits the chargor a general power to deal with the assets in the ordinary course of his business. It is thus ideal for a pool of assets which is constantly changing, eg, inventory, raw materials and receivables. New assets acquired by the chargor and falling within the terms of the instrument creating the floating charge become subject to the charge without the necessity of further documentation. Such is the utility of the floating charge that international lawyers invariably attempt to replicate it in foreign countries; if there is not an identical concept, they will try to construct a functional equivalent using the basic constructs found in local law. The nuances will be different – they will need to be investigated carefully lest the lender proceeds on the wrong premises regarding the legal incidences of the “floating charge” under local law. (c) Security interests over receivables
60
Under the corporations codes of these countries, a charge over an insurance policy is not a registrable interest. England: s 395 Companies Act 1985 . Australia: s 262(1) Corporations Law. Singapore: Companies Act (Cap 50) s 131(1). Malaysia: s 108(3) Companies Act 1965. Although a (fixed) charge over book debts is registrable, it was held in Paul & Frank Ltd v Discount Bank (Overseas) Ltd and Board of Trade [1967] Ch 348 that an interest in an insurance policy is not a book debt. 61 See recommendations for reform along the lines of the Art 9 Uniform Commercial Code in A L Diamond, A Review of Security Interests in Property (1989, HMSO, London).
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Expected cash-flows from revenue producing contracts with the project’s output purchasers can serve as valuable collateral for the project lender. In common law jurisdictions, the collateral can take a few forms.62 The borrower may mortgage the accounts receivable to the lender, ie, he assigns to the lender the right to receive the debt but reserves to himself the right to redeem the debt so assigned. Alternatively, he may charge the accounts receivable. In a charge, the chargee is not entitled to collect the debt or ask for the debt to be paid to him directly. There is a risk that the chargor may dissipate the moneys collected. There is also a risk that if the chargor pays the money into an overdrawn account, the chargee will be unable to claim against the bank.63 The expected cashflow may also be used as a credit enhancer in another way; the borrower may assign the debt in an out and out sale but issue a guarantee for the payment of the debt. Although the assignment coupled with the guarantee is not a legal security stricto sensu, it performs the function of a security. The advantage of structuring the credit enhancement device in this manner lies in the avoidance of the registration requirements under the companies legislation of many countries inspired by the English model.64 How good a security is the assignment of a debt? The payment obligation constitutes the debtor’s end of the bargain with the creditor under an executory contract. There may be various circumstances under which the law excuses the payment debtor from his obligation to pay. Very often, the law construes
62
For a comprehensive treatment of the legal aspects of accounts receivables financing, see Oditah, Legal Aspects of Receivables Financing (1991, Sweet & Maxwell). For a more concise discussion, see Goode, Legal Problems of Credit and Security (2nd ed, 1988, Sweet & Maxwell) Chap V. 63 Much turns on whether the bank receives the money with notice of the chargee’s interest. The bank who receives with notice is liable. If the bank receives the money without notice, it is not liable to account for the moneys had and received to the extent that it has given value for it; the bank is taken to have given value to the extent that the moneys paid in were applied to reduce the assignor’s overdraft. Thomson v Clydesdale Bank Ltd [1893] AC 282, Coleman v Bucks and Oxon Union Bank [1897] 2 Ch 243. This problem is avoided in a legal assignment of a debt in that notice is given to the debtor. 64 For criticism of the existing English regime and recommendations for reform, see Crowther Committee Report (Cmnd 4596, 1971, HMSO) para 5.7.20 et seq, Cork Committee Report (Cmnd 8558, 1981, HMSO), Diamond Report, supra, note 61, para 8.24 et seq. 65 Bolton v Mahadeva [1972] 1 WLR 1009 (installation of defective central heating system prevented the supplier from suing for any part of the contract price). See also Sumpter v Hedges [1898] 1 QB 673 (in an ‘entire’ contract, conferment of partial benefit does not entitle the giver to sue for the value of the benefit conferred unless the benefit is voluntarily accepted by the receiver.)
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the payment-debtor’s obligation to be conditional on the payment-creditor performing his end of the bargain in a satisfactory manner.65 In common law sales, the seller’s non-performance would excuse the buyer from his obligation to pay; indeed it would provide the buyer cause to discharge himself from all further obligations under the contract.66 Even if the seller’s breach does not entitle the buyer to discharge himself from his obligation to pay, the buyer has a right to damages which he may set up against the assignee, whether or not he has notice of the assignment.67 The value of the assignee’s security in the payment obligation is thus diminished by the extent to which the payment debtor may, by reason of the payment-creditor’s breach, be excused from making payment. Lenders should therefore acquaint themselves fully with the terms of the contract so that they can appraise themselves of the risk that they are undertaking. The legal device which the lender can use to enhance the value of his security is to require the output purchaser’s payment obligation to be structured as an independant obligation vis-à-vis the performance obligation. As the efficacy of the security depends on the defeasibility of the payment obligation, the manner in which the payment obligation is drafted is all important. If an independent covenant is intended, it should be clear that the output purchaser is obliged to pay whether or not the output is delivered. He should also covenant not to raise against the assignee counterclaims and defences which he would otherwise be able to raise against the assignor of the debt. The lender would then be entitled to sue for payment notwithstanding the non-delivery or defective delivery of the output required by the output purchaser. The take-or-pay contracts and throughput contracts earlier mentioned are structured upon the notion of independant covenants. The legal efficacy of these indirect guarantees is only as good as the drafting. Frustration/force majeure. The project may be affected by external events which radically change the ability of a contracting party to perform what he has promised. The waters feeding a dam may be diverted by the country further upstream making the continuance of the project futile. Raw material required for the manufacturing process may become impossible to obtain because of a worldwide shortage. Is the output purchaser still bound to
66
Distinction is made between commercial contracts where time of delivery is presumed to be of the essence, and non-commercial contracts where time is not so presumed. In a commercial contract, the performance-debtor’s failure to perform by the time stipulated in the contract would entitle the performance-creditor the right to discharge himself from the contract. Hartley v Hymans [1920] 3 KB 475. 67 Graham v Johnson (1869) LR 8 Eq 36; William Pickersgill & Sons Ltd v London & Provincial Marine Insurance Co Ltd [1912] 3 KB 614; The Raven [1980] 2 Lloyd’s Rep 266.
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his independant covenant to pay notwithstanding there being no further expectation of receiving what he contracted for? Is the supplier of the raw material liable for failing to deliver? The impact of such external contingencies is covered in common law by the doctrine of frustration. In civil law, they are dealt with under the doctrines of force majeure and cause etrangere. The effect of a particular contingency on the contract varies from one legal system to another because different legal systems hold the pacta sunt servanda principle to different degrees of strictness. To constitute a event of force majeure under French law, the event must be unforeseeable,68 irresistible and external to the obligor. The English formulation of frustration is couched in comparatively more liberal terms: it must render the contract illegal, impossible or radically different from what was in the contemplation of the parties at the time the contract was entered into. In a Singapore case,69 the compulsory acquisition of a piece of land by the Government was held to be a frustrating event notwithstanding that the powers were exercised under a notorious piece of legislation; the purchaser of the land was discharged from his obligation to pay the purchase price. The foreseeability of the compulsory acquisition would prevent its constituting an event of force majeure under French law. Even if these related doctrines under the different legal systems consider the supervening event sufficient cause to relieve the obligor of his obligations, they may take effect differently. At common law frustration discharges the parties from their contract pro tanto; the recovery of deposits and suit for benefits conferred are largely determined by the provisions of the Frustrated Contracts Act.70 A party seeking the annulment of a contract under French law is required to apply to court for an annulment order.71 The court does not necessarily annul the contract or terminate it; it may suspend the performance
68
In the opinion of the (French) cour de cassation: Whereas if the irresistibility of an event is in itself alone constitutive of force majeure when its prediction does not permit one to avoid its effects, this is not so when the debtor may normally foresee such an event at the time of entering into the contract. (Cass. Civ. 1re 7 March 1966 JCP 1966 II 14878). Cited in P Marshall, Comparative Contract Law (1994, Gower, Hampshire, England) p 335 Philippine civil law takes a similar approach. See Civil Code of the Philippines Art 1174. See also Arturo Tolentino, Commentaries and Jurisprudence on the Civil Code of the Phililppines (Central Lawbook Publishing Co, Quezon City) vol 4 p 126 et seq. 69 Lim Kim Som v Sheriffa Taiba [1994] 1 SLR 393. 70 UK: Law Reform (Frustrated Contracts) Act 1943. This statute has been widely copied throughout the Commonwealth. See, eg, Singapore – Frustrated Contracts Act Cap 115. 71 Art 1184 Code Civil. If the court annuls the contract retroactively, the parties are required to return any benefits received. If the contract is terminated, the parties are entitled to retain the benefits received.
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if it views the event to be a temporary one. From the perspective of the lender, the prospect of the output purchaser being discharged from his payment obligation diminishes the value of the debt assigned to him. For this reason, lenders require the insertion of a hell-or-highwater clause in which the payment-debtor binds himself to pay notwithstanding the occurrence of certain listed contingencies; the listed contingencies may consist of events which the governing law would otherwise regard as sufficient cause for discharge of the payment-debtor’s obligations. Such express stipulations are likely to be given effect to by the courts. Doctrines like frustration and force majeure can be seen as the legal system’s mechanism for allocating actualized unforeseen and unprovided for risks. Where the parties have expressly provided for the effects of certain contingencies, the party autonomy principle should prevail. Thus unless there are public policy objections, the terms of the hell-and-highwater clause should be enforceable. Moral hazard risk. Thus far we have discussed the lawful excuses which prevent the payment-creditor from suing on the debt. One must also be mindful that in an executory contract, the payment-creditor bears a moral hazard risk – the payment-debtor may fail to perform without a lawful excuse. The payment-creditor and his assignee will have to pursue legal remedies against the payment-debtor. The nature of the legal remedies available depend on both the substantive law governing their relationship inter se and the procedural law of the forum in which the dispute resolution is carried out. Whether the judgment-debtor has a lawful excuse to the suit is a matter of substantive law; creditors would want to choose for the supply contract a governing law which they are familiar with and in which they have confidence. The ease with which the payment-debtor may be sued differs from jurisdiction to jurisdiction. Whether summary judgment may be obtained is a matter for procedure; it will depend on the forum in which the dispute resolution is carried out. To a certain extent, the moral hazard risk may be reduced by a careful choice of the governing law. Choosing the law of an established legal system to govern the contract avoids the doctrinal uncertainties of a less mature legal system. The parties would also plan for a dispute resolution mechanism which is reliable and a forum which affords them the desired dispute settlement procedure. For this reason, arbitration is often chosen as the mode for settlement of disputes as the parties can determine the arbitrators; more importantly an arbitral award
72
New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards.
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rendered in a country party to the New York Convention72 can be enforced in another country which is also party to the Convention. 3. Summary of legal issues which should be addressed in taking security over project assets in a cross-border project finance Cross-border project finance requires the project counsel to traverse the different paradigms found in the diverse legal systems with which the project finance is connected. The concerns which he should have in mind have been discussed above. For the purpose of summary, they may be grouped into the following five areas: (a) Assets over which security interests can be taken. What exactly does the borrower own? Is his interest over the asset a proprietary one which can be freely transferred? Or is his interest more in the nature of a license, ie, he is granted a right to use which may be revoked and which becomes valueless once the terms of the license are breached? Is there any value in taking a security interest over a license? Is it legally permissible to take a security interest over the license?73 Are there any peculiar legal restrictions which inhibit the foreign borrower’s ability to take a security interest over the asset? Is it legally possible to take security interest over future property? Types of security interests. What are the kinds of security interests that can be created against the different project assets? Is it possible to create a floating charge or its functional equivalent under local law? What are the priority rules affecting the security interests? Does the local law prescribe any creditors who are preferred over a secured creditor? Execution against the secured property. How may execution against the secured property be effected? Is the lender permitted to appoint a receiver? What is the extent of the lender’s liability for the receiver’s actions? If a sale of the secured property is to be carried out, what are the legal rules governing the sale?
(b)
(c)
73
In Taiwan, the Statute for Encouragement of Private Sector Participation in Transportation Infrastructure prohibits assignment of the concession or the creation of security interests over the project assets. See Cassingham et al, supra, note 10, at 267. This should be contrasted with the franchise granted to Hong Kong Air Cargo Terminals Limited to build and manage air cargo facilities at Super Terminal 1 of Chek Lap Kok Airport; to enable the franchisee to obtain financing, the franchisee was permitted to assign its franchise rights to lenders who would take over the management of Super Terminal 1 in the event of its failure to operate.
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Is it to be by a judicial sale, a public auction or some method unfamiliar to the lender? (d) Issues pertaining to perfection of the security interest. What steps need to be taken to ensure that the security taken is effective against other creditors and the liquidator of the debtor? What are the formalities to be complied with? In a syndicated or club loan involving sharing of security, are there legal devices similar to the trust concept which allow for beneficiaries of the pool of security interests to be changed from time to time without the necessity of fresh documentation? Private international law issues. What governing law should be chosen for the output sales contract and the assignment? What problems can arise if the output purchase contract is governed by the law of Country A and its assignment by the law of Country B? Does the jurisdiction where the payment-debtor is located permit a foreign law to govern the assignment of the debt?
(e)
E. ENDNOTE
Project finance is best conceptualised as a kind of limited recourse financing. The project sponsor is able to insulate himself from the risk of project failure but lenders would invariably require guarantees and other credit support from the project sponsor in order to be confident about the project sponsor’s commitment to the project. The equity risk must in the end analysis rest with the project sponsor. Nonetheless it remains true that the lenders assume greater risk compared to a normal fully collateralized loan. The risks that attend a project will need to be identified and dealt with. Some of the risks can be reduced. Others can be isolated and borne by willng parties. The role of legal instruments and devices in accomplishing risk reduction and risk spreading cannot be understated. As the efficacy of these instruments and devices vary according to the effect given to them by different jurisdictions, their effect in the jurisdictions in which their enforcement may be sought needs to be investigated. Such legal risks should also be clearly identified and borne in mind. It is one thing to be faced with the consequences of a risk which one has assumed consciously. It is another to be afflicted with a risk which is foreseeable but unplanned for.
*
LLB (Hons) LLM (Columbia); Advocate & Solicitor (Singapore); Lecturer, Faculty of Law, ALEXANDER F H LOKE* National University of Singapore.
doc_721244434.pdf
In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss (or impact) and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled in descending order.
Singapore & Comparative Law 2 SJICL Journal of International Risk Management and Credit (1998) 2 pp 37 – 75
Support in Project Finance
37
RISK MANAGEMENT AND CREDIT SUPPORT IN PROJECT FINANCE
This article surveys risk planning in project finance and the role of the law in facilitating the process of risk spreading and risk reduction. As project finance typically involves an initial high cost-high risk construction and development period followed by a long capital recoupment period, the risks which attend a project should be identified and planned for as comprehensively as possible. These include the legal risks pertaining to obtaining collateral from projects in unfamiliar legal systems. Additional credit support may be required before lenders are willing to participate. In this article, the more common risks are identified and discussed along with the additional credit support that may be necessary to structure a successful finance package.
A. INTRODUCTION 1. What is Project Finance? Project finance is the term applied to a variety of financing structures that have a few features in common. In a project finance, loans for the project are made on a non-recourse or limited recourse basis. Whereas lenders normally assess a loan proposition based the credit-worthiness of the borrower reflected by his asset portfolio and aggregate earning capacity, the lender in a project finance is willing to look primarily to the expected income stream of the project for his repayment. If the project fails or the expected income stream fails to materialize, the liability for repayment of the loan does not pass to the project sponsors and operators – except to the extent expressly assumed by them. Another feature of project finance is the nature of the security package. In contrast to many long term commercial loans which tend to be fully collateralized, the underlying assets which form the collateral for project loans typically do not cover the full amount of the loan. The ability of project lenders to recoup the advancements and interest thereon thus depend substantially on the performance of the project. This accounts for another characteristic of project finance – project lenders scrutinise closely the feasibility studies prepared for the project. This typically involves assessing the technical aspects of the project as well as its economic projections. For undertaking the increased risks of a project finance and incurring the added cost of studying the loan proposals, project lenders charge a higher
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interest rate. Nonetheless lenders who are asked to look primarily (if not wholly) to the future revenues of the project for repayment must be confident of the stability of the income stream. The character of his financing must be in the nature of a lending risk rather than an equity risk. Where the steadiness of the income stream is in doubt, the project may not be a bankable proposition. Additional credit support may be necessary to assure lenders of the base levels of recovery they can expect. Guarantees and performance bonds, in addition to providing that assurance, serve to signal to the lenders the commitment of the parties providing the credit support. Insurance assures lenders that the covered contingencies will not permanently cripple the project. The adept use of credit enhancement devices thus makes the difference between a bankable proposition and one that is not. 2. Attractions of Project Finance The attractions of project finance lie in its features. Project finance packages risks associated with the project into discrete “bundles”. The segregated risks can then be parcelled out to diverse willing parties. It thus allows for parties best able to control or insure against the risks to assume them – it enables efficient risk allocation.1 Splitting up the assumption of project risks in this manner has – in addition to risk spreading – the effect of reducing the associated risks. As a consequence, a project which is unacceptably risky to one party becomes feasible through first, risk spreading and second, risk reduction.
1
This underpins the The Abrahamson Principles formulated in the context of construction contracts: A party to a contract should bear a risk where: 1. The risk is within the party’s control 2. The party can transfer the risk (eg, by insurance), and it is most economically beneficial to deal with the risk in this fashion 3. The preponderant economic benefit of controlling the risk lies with the party in question 4. To place the risk upon the party in question is in the interests of efficiency including planning, incentive and innovation efficiency 5. If the risk eventuates, the loss falls on that party in the first instance and it is not practicable, or there is no reason under the above principles, to cause expense and uncertainty by attempting to transfer the loss to another. “No Dispute – Strategies for Improvement in the Australian Building and Construction Industry” May 1990. A Report by NPWC/NBCC Joint Working Party p 6 cited in Peter Megens, “Construction Risk and Project Finance – Risk Allocation as Viewed by Contractors and Financiers” (1997) 14 ICLR 5 at 8.
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For the project sponsor, project finance enables him to insulate project risks from his portfolio of investments.2 He avoids the risk of bankruptcy from the failure of one project. Although he may be required to provide guarantees as credit support, the guarantee amount may be limited to a level he is comfortable with. Moreover the impact of a guarantee on his balance sheet is less damaging compared to a direct loan even though the extent of liability is the same. Due probably to market inefficiency, the guarantee which is reflected as a footnote to the balance sheet tends to be viewed less unfavourably than a loan reflected directly on the balance sheet. Indeed other credit enhancement devices like take-or-pay contracts may not even be reflected on the balance sheet. Such off balance sheet financing can be extremely attractive to project sponsors as it enables them to avoid the restrictions on borrowing and creation of security interests found in their constitutional documents or existing credit facilities. Project financing assumes increasing importance today as developing economies seek to develop their infrastructure. Infrastructural projects are invariably capital intensive ventures. Financial constraints may hinder a country’s ability to commit its financial resources for the development of its infrastructure. Project financing offers the prospect of private investment in its infrastructural development. Private funding preserves the public coffers. Corollary to this, the participation of private enterprises offers the benefits of commercial discipline. Project feasibility is assessed and undertaken on a commercial basis. If run as a public sector project, considerations like obtaining a reasonable return may not be politically acceptable as the public may view the service to be integral to the functions of a
2
This is usually achieved by incorporating a limited liability company as the special purpose vehicle (SPV) for undertaking the project. Regulators recognise the importance of limited liability companies to capital formation as well as to the encouragement of high risk ventures with potentially high payoffs. For this reason, developing economies have embraced the concept of limited liability companies in their corporations codes. Such is the importance of preserving the sanctity of limited liability companies that common law courts have admitted few exceptions to it. Courts have occasionally disregarded the separate legal personality of the corporation and permitted its liability to pass to its corporators; these invariably involve the employment of the corporate form as a device for fraud. It is however clear that fraud is not constituted by showing that a risky venture is under-capitalised. See Adams v Cape Industries plc [1990] 2 WLR 657 esp 760E (CA); “The Skaw Prince” [1994] 3 SLR 379 (High Court, Singapore). It is possible to obtain non-recourse financing by an express commitment on the part of lenders to look only to the cash-flow generated by the project for repayment of the loans. This manner of structuring non-recourse financing, however, entails careful drafting of the lenders’ non-recourse covenants and is consequently a more costly and less efficient device for achieving the same purpose. Limited liability companies are therefore convenient “off the shelf” devices by which to isolate the risks of a venture.
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government. Private sector participation also permits the employment of efficiency-oriented management techniques which may not be politically acceptable if the project were run as a purely public sector project; for example, a commercial enterprise is able to hire and fire with far fewer constraints than the civil service or statutory body. Permitting the project to be run by commercial enterprises allows a certain insulation from the political factors that inhibit the efficiency of public sector projects. The government continues to exercise its role as the custodian of public interest by setting the terms of the concession and giving the appropriate regulatory responses to unanticipated and deleterious effects of a project.3 The attractions of project finance, therefore, account for the increasing use of BOT and its variants in developing countries.4 The importance of project finance to States is not confined to infrastructural projects. Project finance concepts and structures are also integral to structuring the projects involving concessions granted by governments to exploit its natural resources.5 3. Overview of Article The touchstones of project finance are cash flow and risk analysis. Cash flow is the life-blood of the project. Risk analysis looks at the events which determine whether or not the actual cash-flow falls short of the projected
3 4
5
From the perspective of the project sponsor and operator, the close identification of the project with a public good presents the risk of political populism: see Section B(4)(v). BOT stands for “build, operate and transfer” or “build, own and transfer”. The premise is that the private company will undertake the finance and development of the project and be permitted to recoup a reasonable return for a specified period before handing over the infrastructure to the state. The variants of BOT include: BOO (build, operate and own); BOR (build, operate and renewal of concession); BOOT (build own operate and transfer); BLT (build lease transfer); BRT (build rent transfer); BT (build and transfer); BTO (build transfer and operate); DBFO (design build finance and operate); DCMF (design, construct, manage and finance); MOT (modernize, own/operate and transfer); ROO (rehabilitate own and operate); ROT (rehabilitate own and transfer). The United Nations Industrial Development Organization (UNIDO) has published an extremely useful book on the subject: see UNIDO BOT Guidelines (1996, UNIDO, Vienna). The book on project finance published by Clifford Chance draws heavily from its experiences as counsel in North Sea oil concessions. See Clifford Chance, Project Finance (1991, IFR Publishing, London).
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cash flow. An appreciation of the risk factors is essential to a realistic assessment of the chances of realising the projected cash flow. This paper examines project risks, primarily from the perspective of the lender. In Part B, I will identify the different risks found over the life of the project and discuss how the risks are managed through risk-spreading and risk-minimization techniques. From the perspective of the lender, risk-spreading or risk-minimisation is credit support since any lowering of lending risk acts as credit support for the project and increases the bankability of the loan proposition. In order to ensure that their lending risk does not deteriorate into an equity risk, lenders require credit support from project participants to secure a minimum level of recovery. Part C examines four classes of credit support devices: legal guarantees, indirect guarantees (instruments which are not strictly legal guarantees but which perform similar functions), insurance, and “soft” credit support (commitments or actions which though not legally binding have the effect of assuring the lender). Issues involving the taking of security interests over project assets are discussed in Part D. A separate section has been set aside for discussing this means of credit support because its legal issues – especially in the cross-border context – tend to be more complex. In this Part, I will first discuss the motivation for taking security despite the fact that in many projects, the assets have little liquidation value. I will then discuss the issues involving three classes of property over which security interests may be sought: real property, movables and receivables. I will end by summarising the legal risks involved in cross-border project finance. B. RISK FACTORS: IDENTIFICATION AND MANAGEMENT 1. Feasibility Study Fundamental to assessing the bankability of a project is the feasibility study. The non-recourse basis of loans in project finance, as well as the limited recovery that can be expected from the liquidation of project assets, puts high premium on the reliability of the feasibility study. Moreover, unlike established business enterprises which tend to have a certain track record and a certain degree of diversification, the risks associated with a project loan tend to be highly project specific; the lender does not have the benefit of risk-spreading that comes from diversification of a business enterprise’s undertakings. These factors serve to differentiate a project loan from a normal collateralized loan. Whereas lenders of fully collateralized loans can afford to be somewhat more indifferent to the intended use of the loan, project lenders cannot afford to do so. As they derive their returns almost exclusively
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from the cash-flow of the project, they must be confident first, that the project is technically feasible and second, that the project is economically viable.6 (a) Technical feasibility. A project requiring large capital commitment must involve careful and detailed feasibility studies by reputable experts. Every aspect of the project which impacts on its feasibility has to be carefully studied. A plant must be capable of producing what it is intended to produce in the quality and quantities expected. A pipeline project must be capable of carrying the projected throughput. The market studies which form the basis of cost estimates and revenue projections must be realistic. The lender and its agents would conduct a careful study on the project design, the construction schedule, the start-up performance standards to be satisfied prior to handing over of a turn-key project, and of course, an appraisal of the output projections. A borrower who hopes to secure the commitment of lenders must prepare rigorous feasibility studies which address the concerns of the lenders and instill in the lenders confidence in the borrower’s ability to produce the results promised. Lenders generally prefer projects involving tried and tested technology. These are the projects which will produce the steady cash-flow so essential to servicing the debt obligations. Projects which involve new technology and untested innovations are more properly reserved for venture capitalists; after all venture capitalists have the mandate to participate in risky projects which may produce much fruit for its investors. The mandate of commercial lenders is different; their depositors expect the banks to invest the funds entrusted them in “safe” loans. The capital contribution of banks to projects must therefore be fairly “safe” if their mandate is not to be abused. Nevitt indicates that banks which engage in loans with a spread of 300 basis points and above are engaging in speculative ventures which are more in the nature of an equity risk rather than a lending risk.7 That bank failures can have severe repercussions for
6
7 8
The debt – equity ratio of a typical infrastructure project ranges from 70:30 to 80:20. The high leverage also means that the risks assumed by equity participants is high. A high compensatory rate of return is therefore necessary to attract project sponsors and other equity participants. Depending on the nature of the project, the contractual arrangement and perceived credit-worthiness of the host country, the rate of return required ranges from 18% to 25%. See Jane Walker, “Private Sector Infrastructure Development Funds” in Infrastructure Development in Sri Lanka: Regulation Policy and Finance (Asia Law & Practice, 1997) Chap 10. P Nevitt & F Fabozzi, Project Financing (6th ed, 1995, Euromoney) p 10. The current banking crisis afflicting the Asia-Pacific countries (in particular South Korea, Thailand and Indonesia) underscore the importance of a sound banking system. The literature on bank failures is vast. Some of the more recent ones are: The Causes and Costs of Depository Institution Failures (1995, Kluwer Academic, Boston); Goldstein, Banking Crisis in Emerging
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the state and international economy is well documented;8 regulators therefore impose strict control over the lending policies of banks with consequential impact on their capacity to lend on a non-recourse or limited recourse basis. (b) Economic viability. Closely tied in with the technicial feasiblity of the project is its economic viability. Are the cost estimates overly-optimistic? Do they take into account the contingencies of cost-overruns, currency fluctuations and possible interest rate changes? Lenders must be satisfied that revenues generated by the project are capable of covering operating expenses, debt service obligations, tax liabilities, royalties and other financial obligations. Project finance thus involves a degree of sophistication in credit analysis that extends beyond normal loans. While lenders would engage their own experts to evaluate the feasibility study submitted by the borrower, lenders must be capable of evaluating the technical and financial projections, as well as the assumptions used in the studies. For this reason, banks regularly participating in project finance will have their in-house technical experts who are invariably engineers with a career background in the industry capable of providing their independant evaluation of the feasibility studies. Its creditassessors will also need to be savvy in evaluating marketing projections. Careful scrutiny of the technical feasibility of a project and its economic viability necessarily means that one has to be sensitive to the impact of adverse factors that may assail the project. 2. The Construction and Development Phase The typical profile of an infrastructural project involves a “high cost/ high risk” construction and development period followed by a relatively long “low revenue-low risk” cost recovery period. The construction and development phase constitutes the long gestation period before the project sees any significant revenue stream. Much of the capital required for the project is ploughed in during this period. The unfortunate experience of many projects is one where the required capital outlay escalates into unanticipated
Economies: Origins and Policy Options (1996, Monetary and Economic Dept, Bank for International Settlements, Basle); Andrew Sheng, Bank Restructuring: Lessons from the 1980s (1996, World Bank, Washington DC). Much ink has been spilled over the savings and loan crisis in the United States. The crisis is particularly interesting for the policy errors and the social consequences of the bank failures. See, eg, Benston, An Analysis of the Causes of Savings and Loan Associations Failures (1985, Saloman Brothers Centre for Study of Financial Institutions, NY); Barth, The Great Savings and Loan Debacle (1991, AEI Press, Washington DC); Mayer, The Greatest-ever Bank Robbery: the Collapse of the Savings and Loan Industry (1990, Maxwell Macmillan International, NY).
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(and sometimes unimaginable) proportions. The channel tunnel project, for example, started wth a cost estimate of some £4.7 billion; the total actual cost amounted to above £10 billion.9 A prudent lender will make a careful scrutiny of the assumptions underlying the cost estimates and the estimated period of construction and development stated in the feasibility report. For this reason, potential lenders to Taiwan’s High Speed Rail Project cast a wary eye on the rather optimistic timetable set by the authorities.10 There are a multitude of causes for cost overruns: a devaluation in the currency to be converted resulting in increased cost of imported building material, an embargo against the host country resulting in increased fuel, energy and transportation costs, unexpected legal problems in land acquisition requiring additional expense in litigation or negotiated settlement. A certain measure of control can be exercised over some of these risks.11 Futures contracts and long term supply contracts permit the price of raw materials to be fixed in advance. Risk of currency fluctuation can be hedged through currency swaps. Certainty, however, has its disadvantages. A fixed price for project supplies means that it is unable to take advantage of lower market prices when the market drops. Transaction costs of financial products like swaps will also impact on the profit margin of the project. Delay in the completion of the construction will delay the commencement of revenue-generating operations. The consequences of delay should ideally be borne by the responsible party or alternatively, the party best able to control and minimise the risk.12 As between the lender and the project sponsor, the latter invariably assumes the obligation to ensure that the project progresses as scheduled. This is backed up by the necessary performance bonds, arrangements pertaining to deferral of repayment and capitalisation of further interest payments. The project sponsor will in turn obtain performance bonds from his contractors and sub-contractors in order that the persons having the most control over timely completion of the different project components are made responsible for the consequences of their actions, inactions, oversight or incompetence. It is, however, not always possible to make project contractors
9
“A Stormy Passage to Profit” The Economist 30/4/94. “More money down the hole” The Economist 16/10/93. 10 The concession contract was to be awarded by June 1997, land acquisition completed by December 1997. The guideway construction was scheduled for July 1997 to June 2002 while the supply and installation of the system was scheduled for July 1999 to December 2002. See Cassingham, Chang & Lee, “Taiwan’s High Speed Rail” in Project and Infrastructure Finance in Asia (2nd ed, 1996), pp 264-274 at 266. 11 See discussion at Part B4(ii). 12 See note 1.
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strictly liable for failing to deliver on time. The delay may be caused by external events beyond the control of parties. While contractors may be willing to bear responsibility for delays attributable to them, they may not be amenable to being strictly liable for delays like civil disturbances and acts of God which are beyond their control. Some of these risks are insurable at reasonable premiums, others are not. Amongst the project participants, the project sponsor is often left as the bearer of residual risks. Some lenders avoid the risks associated with construction and start-up by delaying their participation in the lending syndicate till the commencement of operations. These lenders are only willing to assume the operating risks of a functioning plant. The loan capital required prior to the commencement of operations is provided instead by construction lenders. These are lenders who have more experience in construction lending and are better able to manage the loan over the construction and development phase; they also wish to confine the time horizon of the loan to one which they are comfortable with. Their lending commitment is until the completion of the construction or until the completion of the start-up tests; the termination of their lending risk is secured by a “take-out” commitment from the permanent lenders. For assuming the greater risk associated with the prior phases, the construction lenders are compensated by higher fees and interest charges. The take-out obligation is normally activated by the conclusion of start-up tests demonstrating the attainment of performance specifications found in the construction contract. It is thus important for potential lenders to have the capacity to assess whether the proposed performance specifications are acceptable so that they may negotiate for suitable modifications before the loan package is finalised. Lenders guard against the risk of cost overruns and delays by extracting completion guarantees from the project sponsors and interested parties. The completion guarantee may take the form of an undertaking that the construction will be completed by a specified date coupled with an undertaking to service the interest due on the loan. As an alternative to or in addition to the undertaking to service the debt, the guarantor may undertake to provide such further funds as are necessary to cover cost overruns. Completion guarantors may assume the obligation to “take-out” the lenders should the delay extend beyond a specified period. Indeed the financing at this stage may be de facto full recourse financing. It is axiomatic that a perfectly sound commercial proposition can be ruined by the erroneous choice of contracting parties. The key to actualising the potential of a good project and for the completion guarantor, avoiding liability under a completion guarantee, is the selection of financially responsible and technically competent contractors. The consequences for failing to deliver on time should be clearly spelled out. Liquidated damages clauses
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are usually inserted to avoid the doctrinal and practical difficulties associated with proving damages.13 This should preferably be supplemented by a performance bond issued through a financial institution. The latter can serve as valuable collateral14 and has the advantage of avoiding to a somewhat greater extent the credit risk of the contractor. 3. Start-Up Phase The start-up phase commences with the first operations of the project plant or facility. For the construction of a plant to be considered successful, the plant must function at the projected cost and according to the specifications found in the feasibility study. These form the basis for the cost and revenue projections. Incongruence between the actual cost and the projected cost upsets the cash flow estimates by which the debt is to be serviced. A shortfall in the production capacity impacts on the revenue stream as does the inability to produce products of the requisite quality. The rigor of the start-up tests determines the point at which the risks pass between the participants. For this reason, lenders normally require the plant to be proven to function at the capacity and according to specifications before allowing completion guarantors to be released from their obligations.15 Permanent lenders too will require the project to perform as expected before they “take-out” the construction lenders. If there has been an inadequate evaluation of the criteria and standards adopted for the start-up tests, the
13
Liquidated damages clauses avoid the need for a separate hearing for the assessment of damages. It also has the advantage of avoiding the limiting principles which prevent the aggrieved party from proving and claiming the full extent of his damage. The principles governing remoteness of damage and the doctrine of mitigation are two of the more significant limitations. While a liquidated damages clause will not be upheld if it amounts to a penalty, much leeway is given to parties’ agreement; common law courts are increasingly adopting the view that the liquidated damages clause must be shown to be unconscionable or oppressive before they are considered penalties. See Phillips Hong Kong v AG of Hong Kong (1993) 61 BLR 41 (Privy Council, Hong Kong); AMEV UDC Finance v Austin (1986) 162 CLR 170 (High Court of Australia). 14 See Section C(1). 15 In the case of Super Terminal 1 at Chek Lap Kok Airport (HK), the project was deemed completed by an unusually subjective set of criteria: some combination of (a) certification by the project sponsor (b) inspection to the satisfaction of the lenders’ engineers (c) the Airport Authority’s acceptance of the project sponsor’s certificate. This was necessitated by the impracticability of testing the cargo handling facilities by the objective criteria which would have involved bringing “50 000 tonnes of cargo ... to the site and process(ing) them according to an arbitrary pattern”: R Beales, “Case Study: Hong Kong Air Cargo Terminals Limited – Super Terminal 1” in Project and Infrastructure Finance in Asia (2nd ed, 1996), at 162-63.
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lenders may be left holding what is in effect equity risk as the guarantees lapse before the plant is capable of producing the cash flow necessary to support the debt service obligations. The start-up period is therefore the time for trouble-shooting and problemsolving. The technology adopted may fail to deliver. The design of the facility may be deficient. Machinery invariably need to be tuned repeatedly before targeted performance on a sustained basis is attained. It may take many months of testing and problem-solving before the project reaches the end of the start-up phase. 4. Management of Operational Risks and Risks Common to All Project Phases If a risk profile is drawn over the life of a typical project, the period following start-up – the operational phase – will show a steep decline in the risks associated with the project. The project is in its productive stage. Many of the risks affecting this phase are common to those found in the earlier stages of the project life: currency risks, fluctuation in product and commodity prices, natural disasters, civil disorders and political populism. Many of the risk management techniques that are discussed in this section are therefore applicable also to the previous sections. (i) Fluctuation in the prices of raw materials, fuel and transportation A rise in the price of raw materials, fuel or transportation increases the cost and affects the nett earnings of the project. Long term supply contracts may be considered for fixing the price of items like the raw materials and transportation. A form of long term supply contract which gives added assurance is the supply-or-pay contract; in a supply-or-pay contract, the supplier undertakes to provide the extra cost incurred by the purchaser in procuring the supplies from an alternative source should the supplier fail to deliver. It is therefore a guarantee from the supplier that he will fulfill his promises, failing which he will provide the additional cost of securing alternative supplies. Nevertheless, while long term supply contracts provide the advantage of certainty, they are not without their drawbacks. Suppliers who bear the risk of fluctuation in the price of the contracted supplies have to be adequately compensated for assuming this risk. The price charged will tend to be higher. This causes the enterprise to be less flexible in
16
For a more in-depth discussion of this problem, see AC Shapiro & S Titman, “An Integrated Approach to Corporate Risk Management” Midland Corporate Finance Journal 3:41-56 (Summer 1985).
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responding to market changes in the price of the product;16 other more supple manufacturers are able to adjust the price of their products in response to lower cost inputs to an extent that the manufacturer with the long term supply contract cannot. Moreover as suppliers are themselves subject to variable cost items, suitable price escalation clauses may be necessary before they will agree to contract on a long term basis. Some of the risk of price fluctuation is thus shifted back to the project.17 Nonetheless, the advantage of assuring a continuous supply of the production inputs may still commend the long term supply contract. Suppliers to the enterprise may hold a monopoly over the supplies in that locality. The power company managing the local grid may raise its charges after the enterprise has enscounced itself. The transportation company holding a monopoly in the area may extort exorbitant rates which seriously shave the margins of the project. Long term supply contracts give a certain assurance that the cost estimates will be kept within predictable bounds. Futures contracts available on the commodities market may also be adopted to hedge against the price fluctuation in certain raw materials. These are, however, short to medium term hedging instruments. Tailor-made forward contracts may be needed if one wishes to hedge against price fluctuation of an input to be acquired in the more distant future.18 (ii) Financial risk: currency and interest rate fluctuation19 Currency and interest rate risks are not unique to the operational phase. They affect the cost items in the construction and development phase as
17
Whether the risk is shifted wholly or partially back to the enterprise is of course dependent on the formula adopted in the price escalation clause. 18 “Futures” and “Forwards” both refer to contracts where the obligation to perform is in the future but the price paid is fixed at the time of contract. The difference between a futures contract and a forward contract is that the former is traded on exchanges whereas the latter is tailor-made to suit the needs of the particular client. They can relate to commodities like pork bellies and coffee, or financial products like currency and interest rate. See below. 19 Futures, forwards, options and swaps are collectively termed derivative instruments. This is because the value of each of these instruments is derived from the underlying security. As stated in the text, they are useful for managing risks and financial planning. Nonetheless they are also “side-bets” on the value of the underlying asset and if abused, become instruments for gambling. See Lillian Chew, Managing derivative risks: the Use and Abuse of Leverage (1996, Wiley, Chichester, NY). For some financial texts which give more general treatment of the subject matter, see David Winston, Financial Derivatives: Hedging with Futures, Forwards, Options and Swaps (1995, Chapman & Hill, London); Erik Banks, Complex Derivatives: Understanding and Managing the Risks of Exotic Options, Complex Swaps, Warrants and Other Synthetic Derivatives (1994, Probus Publishing Co, Chicago).
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they do the cost items in the operational phase. An appreciation of the Yen against the US dollar increases the price of the imports from Japan if the denominated currency for the loans and financial projections is the US dollar. The revenue stream from a power supply contract fixed in Rupees will suffer a devaluation when the Rupee depreciates against the currency in which the loan is denominated. Currency risks may be hedged in a number of ways. Currency futures contracts enable the entity at risk to fix in advance the conversion rate between currencies for a stipulated date. Another hedging device is the currency swap. In a currency swap, one party expecting a cashflow denominated in a particular currency (say Singapore $) enters into a binding contract to exchange it for a stipulated amount of another currency (say US$). This enables the party owing debt obligations in US dollars to secure the cash inflow in US Dollars even though its receipts and revenues are in Singapore dollars. A third hedging device is a multi-currency loan. If a loan consists of a basket of currencies, the fluctuation amongst the different currencies may offset against one another. However, hedging the currency in which the revenue is denominated against the basket of currencies is also a much more complicated affair. Borrowers in loans made on a floating rate basis run the risk of interest rates rising to their detriment. One way of hedging against this risk is to enter into an interest rate swap: one party swaps his floating rate risks for the fixed rate risks of another party. Should the interest rate rise above a particular level, the party who formerly held the floating rate interest risk is now assured that the difference in interest payments will be made up by supplementary payments from the counter-party to the swap.20
Erik Banks also has an informative book on the Asia-Pacific market: Asia Pacific Derivative Markets (1996, Macmillan Press, Basingstoke, Hants). Accounting practice and regulators are struggling to keep up with the pace of financial innovation. For recent literature, see Managing the Disclosure Risks of Investing in Derivatives (Meredith Brown ed, 1996, Kluwer Law International, London); Hudson, The Law on Financial Derivatives (1996, Sweet & Maxwell); Bettelheim Parry & Rees, Swaps and Off-Exchange Derivative Trading: Law & Regulation (1996, FT Law and Tax, London). 20 For a good concise overview, see Nevitt & Fabozzi, Project Financing supra, note 7, Ch 24. For a more detailed description, see Satyajit Das, Swap and Financial Derivatives: The Global Reference to Products, Pricing, Application and Markets (2nd ed, 1994, Law Book Co). For sample documentation, see Gooch & Klein, Documentation for Derivatives: Annotated Sample Agreements and Confirmation for Swaps and Other Over-The-Counter Transactions (3rd ed, 1993, Euromoney). Also Gooch & Klein, Documentation for Derivatives: Credit Support Supplement. Annotated sample credit support provisions for over-the-counter derivative transactions (1994, Euromoney).
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(iii) Changes in market demand and market price Financial projections used in the feasibility studies may go seriously offmark when the market price of the project product or service is vulnerable to fluctuation. Competition from manufacturers of like or alternative products may significantly diminish the market share held by the project. Competitors who offer better products may undermine the demand for the project product. In the worst case scenario, a collapse in the market for the product or service offered by the project will also mean the drying up of revenue and hence the cash flow to the project. There is also the danger of technological obsolescence. After devoting substantial resources to the development of a plant based on a particular technology, the project participants may find that technological advancement has made their plant uneconomical compared to their competitors. The market survey providing the basis for the recommendation in the feasibility study has to be realistic in its estimation of the anticipated volume and price of the product or service. Internal market studies are not infrequently required to be backed up by the reports of independent marketing consultants. The assurance that they provide comes in the form of the damage to their reputational capital should their opinion fail to be sufficiently circumspect; there is also the prospect of legal liability for negligent misstatements. Projects which are ideal for project financing are those with predictable and stable cash flow patterns. Highway projects, power generation plants and high speed rail fall into this category. The nature of the projects ensures a certain hold on the market for the product or service offered. The driver who does not wish to pay the toll for a highway may have the option of travelling along the old trunk road; but the savings in time and convenience offered by the highway will cause him to use the highway for long distance travel. An internal rate of return21 sufficiently attractive to attract project sponsors and lenders is invariably worked into the concession granted by the relevant government authority. With good government support and natural monopoly afforded by the nature of the project, the returns to the
21
Defined as the discount rate at which the net present value (NPV) of the project becomes zero. The constraints of space do not admit elaboration of NPV and the internal rate of return (IRR). A more detailed explanation can be found in any basic finance text. See, eg, Brealey & Myers, Principles of Corporate Finance (5th ed, 1996, McGraw Hill) Chap 3 and 5. 22 Government support has been crucial for the profitability of UEM, the company having the controlling shares in PLUS, the company managing the North-South Highway in Malaysia. Despite protests by consumer groups, the Malaysian Government permitted a toll
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equity contributors and lenders are assured.22 Another way which projects can be insulated from movements in the market price of its products or services is to enter into a long term contract with potential output purchasers. The value of such contract is further discussed in Section C(2). (iv) Disruption of Operations A variety of unwelcome events can potentially disrupt the operations of a project. Fires, civil disorders, natural disasters are but a few examples. Where insurance is obtainable, lenders will normally insist that adequate insurance be obtained. Otherwise, the project may find itself short of funds to repair the damage. Lenders may then be compelled to advance further sums in order to have the chance of obtaining the recoupment of the principal advanced. Events beyond the control of the parties may intervene which under the general law governing the contract excuse the parties from the performance of their obligations. This is covered in English law by the doctrine of frustration and in France law by the doctrine of force majeure. Contractors
increase of 3.74 sen a kilometre on the original rate of 7.5 sen a kilometre over a 3 year period from September 1996. The profits of UEM jumped 90 per cent from M$269.6 million to M$513.2 million between 1995 and 1996. “UEM profit nearly doubles thanks to tollroad firm” Business Times (Singapore) 21/03/97. Indeed the Malaysian Government has indicated that if the concessionaries are asked to widen the highway and to provide additional facilities, the concession may be extended by another 17 years from the 23 years now remaining under the original concession: see “Tolls to remain on Malaysian Roads for 40 more years” Asia Pulse 27/5/97. One analyst described the project as “sustainable, recessionproof toll-based earnings”: see “Malaysia’s UEM to ring in higher net profit for 1996 ...” Agence France-Presse International 14/3/97. Indeed, such is the profitability of UEM that it has secured a short term rating of P1 and a long term rating of AA2 by the Ratings Agency Malaysia (RAM): “Ratings of Malaysian Highway Builder PLUS Bhd Reaffirmed” Asia Pulse 22/5/97. The Super Terminal 1 project at Hong Kong’s Chek Lap Kok Airport is more exposed to market forces. The volume of cargo passing through and the pricing of charges is subject to competition from regional airports as well as the smaller facility run by Asia Airfreight Terminal Company Limited. If there is any natural monopoly, it consists of only the cargo necessarily passing through Hong Kong Airport and the limited capacity of the competing cargo facility. (Super Terminal 1 has a capacity of 2.6 million tonnes per annum compared to the competitor’s 400,000 tonnes per annum.) The growth in cargo volume passing through Hong Kong and the track record of HACTL (the project sponsor and operator) were causes for confidence in the viability of the project. The willingness of lenders to commit to the loan package demonstrated the confidence in the future of Hong Kong Airport as well as confidence in competitiveness of project sponsor/operator, HACTL. See R Beales, supra, note 15.
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may consequently be under no obligation to perform and thus suffer no liability for failing to do so. Project participants may leave the risk allocation to the general law but it is preferable to define the circumstances under which a party is excused and the consequences therefrom.23 (v) Political Risk The government hosting the project has an interest in regulating the manner in which the project carries out its activities. If the project emits noxious fumes or releases toxic effluents into the rivers, the government in fulfilment of its duty to its populace should impose suitable sanctions. In an extreme case, the operating permit of the project should be terminated. However, politicians do not always act rationally or in a principled manner. Licenses may be revoked for reasons of political expediency. Foreign interests are particularly susceptible to political populism.24 Local business interests may stir up a public outcry against the award of contracts to foreigners who are objectively more competent and offer a more reliable track record. The jealousy that comes with the profits from the local economy to a foreign project sponsor often blinds the eyes of the detractors from the benefits contributed to the local economy by the project sponsor. Expropriation is often identified with nationalism in newly independent countries in the post-colonial era. In efforts to shake off the dominance of foreign enterprises over the local economy, foreign enterprises were nationalised. The tide of expropriation has subsided with the realisation that carefully chosen foreign investments can develop the local economy.25
23 24
See further discussion of this in the context of security over receivables in Part D(2)(c). A recent example is that of the Enron power project at Dabhol, Maharashtra in 1995. Doubts over the fairness of the deal precipitated the public outcry which led to a subsequent revision of the deal by the new state government. (The parties constituting the new state government, pursuant to its election platform, originally intended to cancel the project but relented after subsequent negotiations proved fruitful.) See Bibek Debroy, “Reforming the Power Sector – An Indian Perspective” in Infrastructure Development in Sri Lanka: Regulation Policy and Finance (Asia Law & Practice, 1997) Chap 8. 25 The increasingly liberal climate is reflected in the different national investment codes and multilateral investment codes. For a survey, see Ibrahim Shihata, “Problems relating to Entry of Foreign Direct Investment” in Current Legal Issues in the Internationalization of Business Enterprises (LH Lye et al ed, 1996, Butterworths, Singapore). 26 Studies show that the incidences of indirect expropriation has overtaken the incidences of direct expropriation. See, eg, Minor, Developing Countries and Multinational Corporations: Why Has the Expropriation Option Fallen from Favour (1986). 27 The dispute which went for arbitration before the ICSID tribunal resulted in a series of awards which are found at (1992) 89 ILR 366-662. For comment on the arbitration awards, see M Sornarajah, “ICSID Involvement in Asian Foreign Investment Disputes: The AMCO and AAPL” Cases (1995) 4 AsYIL 69.
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Nonetheless, the spectre of expropriation persists.26 In Amco v Indonesia,27 Amco (Asia) entered into a joint venture with Wisma Kartika, an Indonesian corporation controlled by an army pension fund. The venture was to build a hotel complex located in Jakarta – the Kartika Plaza. When the dispute between the joint venturers proved intractable, Wisma with the assistance of the Indonesian armed forces occupied the plaza and took over the project. While the de facto expropriation of Amco’s share in the venture by a quasigovernment body did finally end with the award of compensation to Amco, the arbitration process was arduous and the result by no means assured. Foreign participants often co-opt locals who are positioned to provide the political buffer against influences that would otherwise assail the project. A project consisting of both foreign and local participants is less susceptible to political mood swings against foreigners. Local participants with good connections are also better able to liaise and negotiate with the host government. However, as the Amco case shows, local participation also entails the danger that the local participant may turn against the foreigner. Adverse political action may also assume the form of increase in import and export tariffs or increase in income and capital taxes. Although the consensus of economists is that trade liberisation and the lowering of trade barriers generally benefits the development of a country,28 import and export tariffs are a convenient source of revenue. They may also be invoked for a variety of reasons. The desire to nurture infant domestic enterprises and the imperative of preserving the indigenous culture are but two of the reasons commonly cited. Income and capital taxes may be raised or lowered according to the fiscal policy of the nation; this, in turn, is a function of the economic circumstances of the country and its competitiveness vis-à-vis its competitors. As government policy evolves to meet changing circumstances, tax advantages may be cancelled and preferential quotas and tariffs removed. A means of reducing the exposure to the caprices of national politics is the use of an international consortium of lenders. A host country is less likely to embark on actions which adversely impact on a project and its lenders if the lenders are from capital exporting countries on whose goodwill the host country depends. A further way to bolster the project is to involve international lending agencies like the World Bank, the Asian Development Bank and other regional development banks. The project loan package is structured such that a default on the commercial loan results in a default on the loans from these international agencies. Cross-default clauses may be used to link the commercial loan to the loans made by these agencies.
28
For an excellent account of the historical development of trade theories, see Douglas A Irwin, Against the Tide: An Intellectual History of Free Trade (1996, Princeton University Press).
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An event of default will result in cross-default in a number of loans, resulting in a lowering of the country’s credit rating. Even the best intentions of a government may be overwhelmed by changes in circumstances. A government which has offered assurances about convertibility of local currency into foreign currency may suddenly be confronted with an economic crisis which necessitates the revocation of its prior promises. Civil disorders, insurrections and civil wars may overcome the ability of the government to protect the investments in the project. To encourage foreign investment in developing countries, the World Bank has set up the Multilateral Investment Guarantee Agency (MIGA) to provide insurance unavailable from commercial insurers. The terms of the Convention setting up of the MIGA provide for four broad areas of risk coverage: (i) currency transfer risk;29 (ii) expropriation risk;30 (iii) breach of contract31 and; (iv) war and civil disturbance risk.32
29
Art 11(a) (i) MIGA Convention: “ ... any introduction attributable to the host government of restrictions on the transfer outside the host country of its currency into a freely usable currency or another currency acceptable to the holder of the guarantee.” The insurable risk extends beyond explicit refusal of the application to convert the currency to undue delays to act on the request: Operational Regulations of the Multilateral Investment Guarantee Agency para 1.24. 30 Art 11(a)(ii) MIGA Convention: “... any legislative action or administrative action or omission attributable to the host government which has the effect of depriving the holder of a guarantee of his ownership or control of, or a substantial benefit from, his investment ...” The terms were drafted widely to recognise that expropriation can be direct (eg, nationalisation) as well as indirect (eg, revocation of license, change in regulations to require increased local equity participation). The coverage, however, does not extend to “nondiscriminatory measures of general application which governments normally take for the purpose regulating economic activity in their territories”: Art 11(a)(ii). General increase in taxes and tariffs which are not aimed specifically at the project would not be covered: see Regulations para 1.36. However, insurance coverage does extend to “creeping” expropriation, ie, the host government imposes a series of measures in which each measure if taken separately is ostensibly in exercise of the government’s legitimate right to regulate the business activities within its territory but which when taken cumulatively has the effect of expropriating the investment. See Shihata, Multilateral Investment Guarantee Agency and Foreign Investment (1988, Martinus Nijhoff) pp 124-131. 31 Art 11(a)(iii) MIGA Convention: “... any repudiation by the host government of a contract with the holder of a guarantee, when (a) the holder of a guarantee does not have recourse to a judicial or arbitral forum to determine the claim of repudiation or breach, or (b) a decision by such forum is not rendered within such reasonable period of time as shall be prescribed in the contracts of guarantee pursuant to the Agency’s regulations, or (c) such a decision cannot be enforced.” 32 Art 11(a)(iv) MIGA Convention: “... any military action or civil disturbance in any territory of the host country ...”
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The protection provided by MIGA extends in many respects beyond the coverage provided by national investment guarantee agencies. For example, national investment guarantee agencies normally treat breach of contract as an expropriation risk and defines the risk coverage in an accordingly restrictive manner. MIGA’s coverage of contractual breach is far wider and includes undertakings given under a stabilisation clause. While expropriation risk insurance coverage does not include regulatory measures of general impact not specifically targetted at the investment, the breach of contract guarantee extends to these measures as long as the host country has given to the project sponsor specific undertakings regarding say, preferential tax rates or export quota. The guarantee scheme is available only to developing member countries.33 Before the contract of guarantee is concluded, MIGA requires the host country to add its approval; amongst other things, this aids the recoupment of its payouts from the host country when adverse events are attributable to the host country.34 It is noteworthy that apart from war and civil disturbance risks, the other risks are largely within the control of the host government. To project sponsors and lenders, international agencies like ICSID35 (which arbitrated the Amco dispute), the World Bank and MIGA help to stabilise the project environment and act as restraints against potentially capricious actions on the part of host governments. They therefore have the function of lowering the political risk and in the case of MIGA, of assisting project participants by taking some risk off them. C. CREDIT SUPPORT AND ENHANCEMENT Project finance is typically highly leveraged. In infrastructural projects, the typical debt-equity ratio is about 70:30; indeed debt-equity ratios of 80:20 are not uncommon. Without credit support and credit enhancement devices, the consequences of project failure would fall heavily on the lenders. The concentration of risks upon the lenders often makes financing on a totally non-recourse basis an unbankable proposition. It is thus unrealistic to expect
33 34
Art 14 MIGA Convention. The Agency is under an obligation to recoup its guarantee payout. Art 18(a) of the Convention establishes the basis under International Law for guarantor agency to be subrogated to the rights of the insured so that it may proceed against the host country for recoupment of its payout. 35 The International Centre for Settlement of Investment Disputes. See further, Convention on the Settlement of Investment Disputes: Analysis of Documents concerning the Origin and Formulation of the Convention (1970, ICSID, Washington).
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lenders to look to the project cashflow as the exclusive source for repayment of the loans advanced. While lenders in project finance accept an increased level of risk compared to fully collateralized loans, they must be assured that their contribution to the capital requirements of the project remains a lending risk. In the event of cost overruns, the lenders should not be found trapped and practically compelled to advance additional loans; there should be a firm and preferably a legally binding commitment on the part of the project sponsors (or other third parties) to infuse fresh capital in the event of such a contingency. If the plant is consumed by fire, there should be found insurance which provide the funds for reconstruction of the plant. Structuring an acceptable project finance thus involves devising an acceptable distribution of risks amongst the various interested parties. This section discusses the various risks spreading techniques that may be adopted in a project finance. 1. Guarantees Guarantees are binding commitments on the part of the guarantor to answer for default in the performance of specified obligations. Guarantees can take many forms. The most basic form assures the lender that the guarantor would pay up on the indebtedness of the borrower should the borrower fail to pay. Performance bonds are a form of guarantee – they are issued by or on behalf of a contractor assuring satisfactory performance of his obligations. The construction contractor or equipment supplier may issue a guarantee covering the timely performance of his obligations. For added security, the beneficiary requests for the guarantee to be issued by a bank. As the nature and extent of a guarantee can be tailored to suit the risk preference of individual guarantors, they are very flexible instruments for risk-spreading. The guarantor may issue an unlimited guarantee for the loans disbursed by the guarantor. Alternatively, he may issue a partial guarantee covering only a stated percentage of the loan. If there is no one guarantor who is willing to assume liability for the entire amount, a few guarantors may be found each of whom will assume a stated proportion of the debt owing; the liability assumed by the individual guarantors will thus be several, not joint and several. Guarantees enable additional credit support to be provided where there is a shortfall in the underlying collateral. Thus for projects located in economies where market conditions and the legal infrastructural limit the realisable value of the collateral, project lenders typically require the project sponsor’s head office to guarantee the loans advanced to the Special Purpose Vehicle (SPV) undertaking the project. Guarantees permit project risks to be shared by persons other than the borrower who are interested in the project and who find it in their interest
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to give guarantees to the lenders. One such class of persons are the suppliers. Project suppliers may be willing to issue guarantees to an extent that is commensurate with their interest in the supply contract. Suppliers of manufacturing equipment will probably be amenable to issuing guarantees covering the performance of the equipment supplied. Where the contract is an especially lucrative one, they may even be persuaded to guarantee certain debts of the customer. Similarly potential suppliers of manufacturing inputs to the completed project may be willing to guarantee part of the indebtedness of the project to secure future orders. Output purchasers who have an especial interest in the product of the project may also be amenable to guaranteeing the debts of the project. A manufacturing facility which appreciates the importance of an adequate power grid may even be keen to add his guarantee to ensure the success of the proposed power plant; indeed, his participation in the success of the power plant may earn him special concessionary rates or preference in the allocation of the resource. In the field of petroleum extraction, petroleum companies who are interested in the project pipeline may – in addition to their obligations under the throughput contract – be expected to guarantee the debts of the SPV constructing the pipeline. As a guarantee is a personal instrument given by the guarantor, it is only as good as the credit-worthiness of the guarantor. While a lender will have little hesitation in taking a guarantee from a company in a strong financial position, they will attach little value to one which is issued by a company which does not have a strong asset base. For this reason, lenders often require the guarantee to be issued by a financial institution. The project sponsor or operator who seeks a guarantee from the supplier of goods pertaining to the reliability or quality of the goods – a performance bond – would also require it to be issued through a financial institution. The intervention of the financial institution is assuring for a few reasons. As a financial institution trades on its reputation, it is unlikely to dishonour its promise. The beneficiary of the guarantee thus avoids the risk of the performing party disputing the validity and enforceability of the guarantee; the unwelcome prospect of enforcing the guarantee through litigation is thus avoided. This consideration is especially important when the performing party is located in a jurisdiction with poor legal infrastructure. Another reason for the attractiveness of the performance bond issued by a financial institution is the fact that the financial institution invariably deals only in documents
36
The autonomy of the performance bond from the underlying transaction is a fundamental principle in banking law. See Bocotra Construction v AG (No 2) [1995] 2 SLR 733 (CA, Singapore); Edward Owen Engineering Ltd v Barclays Bank International Ltd [1978] QB 146 (CA). Also Art 2(b) ICC Rules for Demand Guarantees (ICC Publication No 458) (1992,
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and does not concern itself with the underlying breach.36 The consequence is that the bond must either be unconditional, ie, on demand, or conditional upon certification of the breach by specified experts, eg, appointed professional engineers or surveyors. In either case, the beneficiary of the guarantee avoids the moral hazard risk of the performing party. Some infrastructural projects may be of such importance to the economic development of the host country that the host government may add its guarantee to boost the credit of the project. For example, the government may guarantee minimum cash flows, or undertake to meet the cost overruns in the construction of the plant.37 Such guarantees have effects beyond the financial aspects. The participation of the host government is a good indication of the favour with which the project is regarded and the importance which it is accorded; government involvement, whether through direct capital injection or through guarantees, would thus lower the political or sovereign risk associated with the project. Governments other than that of the host country may also add their guarantees. The home government of the equipment exporter may also guarantee the repayment obligations of the project; such may be the imperative of encouraging local exports or enhancing international prestige that the equipment exporter’s home government may be willing to lend its credit to the project. 2. Indirect guarantees: take-or-pay contracts, throughput contracts and tolling contracts. Long term contracts with output purchasers are the source of cashflow by which the lenders may be paid. Take-or-pay contracts, throughput agreements and tolling agreements are in substance guarantees of cashflow for the project. In a take-or-pay contract, the output purchaser commits himself to make periodic payments of specified amounts whether or not the product contracted
ICC Publishing SA, Paris). The common law admits few defences to a call to pay on the bond once the terms upon which the bond may be called are satisfied – the only judicial exception is the “fraud exception”. UK: United City Merchants (Investments) Ltd v Royal Bank of Canada [1983] 1 AC 168. Singapore: Bocotra Construction v AG (No 2), supra. This exception is, however, narrowly construed – fraud must be in the documents presented to the bank. Fraud in the underlying transaction appears immaterial to the question of whether the bank is still required to pay. The autonomy principle thus takes precedence over the “fraud unravels all” principle. See Loke, “Injunctions and Performance Bonds” [1995] SJLS 682. 37 Indeed governmental involvement is in some cases crucial to the willingness of project sponsors to participate. In Philippines, the assumption of market risks and foreign exchange risks by the Philippines Government was crucial to the success of BOT power projects. See “Manila battles against the past” Project and Trade Finance March 1995 pp 26-28.
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for is delivered. His obligation to pay is thus independent of the actual delivery of the product. It is also independent of the quality of the product delivered. The borrower and the lenders are thus assured of funds for servicing the project’s debt obligations.38 The throughput agreement is similar to the take-or-pay contract except that the counter-party is the user of a facility. The most common subject matter for a throughput agreement is a pipeline. The user promises to pass a specified minimum amount of petroleum or gas through the pipeline; he undertakes to make the payment associated with the minimum use whether or not he actually passes the minimum amount through the pipeline. The amount specified is usually pegged to the cash flow necessary to cover the operating cost and the debt service obligations. The tolling agreement is a variation of the throughput agreement. The term is applied to an agreement between a processing facility and its customers who send their raw materials to the facility for processing. In a tolling agreement, the customer promises to send a minimum quantity of material at an agreed rate. The guaranteed payment may take the form of a capacity reservation fee. The strictness to which a purchaser is held to his payment obligation is largely a function of how the obligation is drafted. As a buyer’s obligation to pay is normally construed to be dependant in some way on the seller performing his part of the bargain, the independence of the two obligations must be manifest. While the more developed legal systems give due recognition to contracting parties’ conscious assumption of onerous obligations on the pacta sunt servanda principle, adjudicators in less sophisticated legal systems may subordinate the pacta sunt servanda principle to the perceived need to address the seeming unfairness of the obligation assumed. Parties dealing in less developed legal systems should therefore investigate whether the covenants they normally use have the same effect. Tightly drafted long term contracts which virtually guarantee the cashflow to a project are valuable as collateral. Indeed lenders often insist on such virtual guarantees so that the proceeds may be assigned to them as security for repayment.39 There are a couple of ways by which the benefit of such contracts may be appropriated to the exclusive benefit of lenders. The right to receive payment may be charged or assigned to the lender. If there are
38
See further, P Nevitt & F Fabozzi, Project Financing (6th ed, 1995, Euromoney) pp 276288; Ryan & Fife, Take-Or-Pay Contracts: Alive and Well in California (1987) 19 Urb Law 233; Nolan, Take-Or-Pay Contracts:Are they Necessary for Municipal Project Financing? (1983) 4 Mun Fin J 111. 39 See Section D(2)(c).
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several lenders, the receivables may be assigned to a trustee who opens an account into which the output purchasers are obliged to make payment. The moneys in the account are thus held on trust for the exclusive benefit of the lenders. Such arrangements enable lenders not only to be protected against the uncertainty of future cashflows, they also insulate lenders from the difficulties that attend the project’s insolvency. In an infrastructural project where the government is the purchaser of the output (eg, power generation projects), the government may enter into a long term contract for the supply of the output at a pre-determined price. This effectively guarantees the cash flows to the project. The risk of price fluctuation – and hence the element of market risk – is removed. Whether the government purchaser is willing to assume a payment obligation independent of the product delivery will depend on how keen the government is to see the completion of the project. While such commitments insulate the project from the perils of the market, the market risk is replaced by the political and sovereign risk earlier discussed.40 3. Insurance The value of insurance as credit support is rather self-evident. If the plant is destroyed by an insured event, the insurance proceeds provide the means for reconstruction of the plant – in part if not in whole. While the insurance would be taken out by the Special Purpose Vehicle undertaking the project, lenders not infrequently require that they be beneficiaries of the insurance policies. The lenders usually also negotiate for the discretionary power to use the money for reconstruction and repair, or to credit the insurance moneys against the debt owing. The latter “cashout” option usually signals the demise of the project unless project participants are able to arrange for a fresh injection of funds toward the reconstruction and repair of the damaged plant. The range of commercial insurance available is quite wide. The “allrisk” builder’s insurance covers losses occasioned during the construction phase. It applies to all perils which are not specifically excluded but does not generally extend to losses that arise from the acts attributable to defaults, eg, payment under a liquidated damage clause. Force majeure insurance provides cover against external events which disrupt the operations of the
40
Fortunately, the room for hedging this risk is greater with the advent of MIGA. See Section B(4)(v). The contribution of MIGA as a stabilising force to the project environment is better appreciated if one is mindful of the limited role that international law otherwise plays in protecting investments. On this, see M Sornarajah, The International Law on Foreign Investment (1994, Cambridge University Press).
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project. System performance insurance covers the risk that the technology or the equipment does not perform at the anticipated level. Although not all risks are insurable or insurable at an acceptable premium, the creation of MIGA has reduced somewhat the lacuna left by commercial insurers. The security that insurance provides to the project, however, is not complete. Insurances lapse. It is important for lenders to ensure that premiums are paid and that they are kept informed of events which affect the effectiveness of an insurance. For this reason, lenders sometimes require the insertion of a clause in the insurance contract wherein the insurer undertakes to inform the lenders of events or actions which affect the effectiveness of the insurance coverage. As insurance contracts are contracts uberrmae fide, insurers are entitled to avoid liability for material non-disclosure; lenders therefore bear the risk that an insurance is rendered valueless for the failure on the part of the insured to provide full and frank disclosure of all the material risks. 4. “Soft” credit support Credit support need not necessarily be legally binding commitments. Non legally binding commitments can also be effective devices for risk minimization and risk spreading. The project sponsor’s home office, while chary of assuming further financial liability for the project, may yet be willing to provide such management and technical assistance as are necessary to ensure the success of the project. What is at stake here is the reputational capital of the promisor. The potential damage to the promisor’s reputation and credit standing should the failure of the project be found to be due to the promisor’s failure to honour its promise may be sufficient assurance to the lenders. Other types of such “soft” credit support include allowing the project vehicle to use a name which manifests a close association with the project sponsor. It is sometimes clear from the nature of the credit support that the promisor undertakes no legal liability. Where the project sponsor permits a derivative of its name to be used for the SPV, for example, the company law of most jurisdictions provide for automatic insulation of the liability of the two companies. A commitment on the part of the promisor may be ambiguous as to whether the promisor assumes a legal undertaking or merely a moral commitment. The context and the wording of the commitment will have
41
The facts of Kleinwort Benson Ltd v Malaysian Mining Corp Bhd [1989] 1 WLR 379 are instructive. The defendant was the holding company of MMC Metals Ltd to whom the plaintiff-bank provided a loan facility of some £10 million. During the negotiations leading up to the loan agreement, the plaintiff-bank was unwilling look solely to the credit of MMC Metals but the defendant was unwilling to guarantee the borrowings of MMC Metals Ltd.
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a determinative effect on the construction of the undertaking given.41 It is, however, important to bear in mind that courts presume commercial agreements to have legal effect; the nature of the promisor’s commitment should therefore be clearly stipulated if he does not intend to assume legal liability. I have earlier alluded to the government’s participation in a project as a means of risk reduction. A government which has a reputation for honouring its word can by little gestures provide the extra credit support necessary to convince the lenders that the project is a bankable proposition. In the Hong Kong telecommunication project, the gesture took the form of a brief acknowledgement by the Hong Kong Government that it would take into account the lenders’ concerns before embarking on any course of action affecting the license.42 Indeed that was the only participation or support by the Hong Kong Government in the project. It was found sufficient by the lenders. D. COLLATERAL IN PROJECT FINANCE 1. Motivation for acquiring security interest over the project assets In a project finance, the realisable value of the collateral tends not to cover fully the loans advanced. This is because the assets involved in a
After prolonged negotiations, a compromise was reached. The Defendants issued two letters of comfort which stated, inter alia, that “it is our policy to ensure that the business of [MMC] is at all times in a position to meet its liabilities to you [under the loan facility agreement].” When MMC later became insolvent, the issue arose whether the defendant had assumed a legal liability toward the plaintiff. The judge of first instance, Hirst J, held that the defendants had assumed a legally binding commitment to the plaintiff but the Court of Appeal disagreed. The Court of Appeal construed the comfort letter to manifest only a representation regarding policy of the defendant existing at the time the letter was issued. As there was no misrepresentation of its policy at the point which the representation was made, there was no cause of action in misrepresentation. The limited construction put on the comfort letter by the Court of Appeal continues to cause some controversy: see, eg, Banque Brussels Lambert v Australian National Industries Ltd (1989, unreported. Noted in Tyree 2 JCL 279). The present author’s view is that what swung the balance in favour of the defendant was a combination of both the context in which the comfort letter was given as well as the wording of the comfort letter. Project counsel would do well to keep a detailed record of the negotiations leading up to the final wording of the comfort letter. While the parol evidence rule may limit the use of such records, Kleinwort Benson demonstrates that it is permissible to use the negotiation process to lay the context leading up to the final draft of the letter of comfort. 42 John East, “BOT Projects in Asia: the Concession Agreement and the Allocation of Risks” in Project & Infrastructure Finance in Asia (2nd ed, 1996, Asia Law & Practice Publishing Ltd), pp 41-52 at 43.
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project finance tend to be illiquid and lose their value once the conditions necessary for supporting the cash-flow no longer exist. The pipeline under the sea has little value if there is no oil to put through it. The plant which is unable to manufacture products of sufficiently satisfactory quality is unlikely to fetch a price which appoaches even its cost of construction. The individual capital assets comprising the project finance have a much diminished realisable value when they are detached from the project. Nonetheless having a first priority to call on the assets of a project – albeit assets of insufficient value to cover the loan – is preferable to being an unsecured creditor. Even if the liquidation of the assets does not allow for full recovery of the loan advanced, the secured creditor has priority over the unsecured creditors. They are likely to recover more than if they were to take no security at all. Moreover if the lender’s security interest covers substantially the operating assets of the company, the collateral can be sold off as an operating unit and would fetch a higher price than if the assets were liquidated piecemeal. While such a manner of disposal would also be the aim of the liquidator,the lenders’ ability to do so may be more expeditious;43 the operating unit may therefore be disposed of before its market value drops significantly. The security interest can also be defensive in nature. The lender’s security interest checks the borrower’s ability to dispose of the assets or to grant security in favour of other creditors. Lenders can of course seek to achieve these purposes by the use of a negative pledge clause; however, the negative pledge clause is strictly a personal covenant with the debtor which is not binding on third parties. The right to sue on the breach of covenant avails him little if the debtor is insolvent. There are of course ways to sue the purchaser or lender who takes the property with notice of the negative pledge clause;44 however the practical and doctrinal difficulties associated with prosecuting the suits render them less advantageous (and less convenient) than obtaining a security interest.
43
This is qualified to the extent that the reorganisation regime imposes a moratorium on the enforcement of security interests. In Singapore, the secured creditor, in addition to suffering from the disadvantage of not being able to enforce his security interest, is not entitled to vote on the plan proposed by the judicial manager: r 74 Singapore Companies Regulation (Cap 50, Reg 1). 44 One possible recourse is to sue under the tort of interference with contractual relatons. The dictum of Jenkins LJ in DC Thomson & Co v Deakin [1952] Ch 646 at 690-699 contains the classic statement of the elements of the tort. Another recourse is to sue the purchaser under De Mattos v Gibson (1858) 3 De G & J 276. Note, however, the ambit of De Mattos v Gibson: see Tettenborn, “Covenants, Privity of Contract and the Purchaser of Personal Property” (1982) 41 CLJ 58. See also Cohen-Grabelsky, “Interference with Contractual Relations and Equitable Doctrines” (1982) 45 MLR 241.
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There is another motivation for taking security which is peculiar to banks. The regulatory authorities invariably place a limit on the amount of unsecured loans that a bank can have in its lending portfolio; it may be more advantageous from the bank’s perspective to make a collateralised project loan – albeit one whose realisable value is uncertain – than a straight unsecured loan. 2. Three classes of property (a) Security interest over real property The value of project land as collateral requires little elaboration. In capitalist economies where free alienability of land is a given, the worth of the collateral is largely a function of economic factors. Even then, legal considerations have a definite impact on the value of the land as a collateral. A re-zoning of the land and a change in the use to which the land can be put can have a significant impact on the value of the land. Agricultural land which is approved for industrial use will appreciate in value. Industrial land which is re-zoned as low-rise residential land is likely to fall in value unless there is a very robust housing market. Doctrines governing ‘takings’ and legitimate expectations restrain government actions and help protect the value of the land. Invariably there will be nuances found in the different legal system which impact upon the value of project land as collateral. The restrictions on the state’s competence to acquire land compulsorily are different in Singapore than in the United States or the Philippines. Different standards would also be applied to determine whether compensation is payable and how much is payable to the owner of the land to be acquired. Nonetheless the differences are reasonably comprehensible as the legal framework of these capitalist economies proceed from certain common assumptions. Indeed they are very often derived from familiar legal traditions and use a familiar vocabulary. The above premises which underlie the legal systems of capitalist economies and hence the value of land as collateral may not be found in socialist countries. While many of these countries are increasingly embracing the principles of market economics and undergoing economic liberalisation, the concept of land ownership and free transferability of land remains inimical to the political idealogies of some of these countries. In Vietnam, for example,
45
Article 17 Constitution (1992). See also Art 1 Law on Land (14/7/93) and Art 690 new Civil Code (28/10/95). For comment on the entrenchment of this notion in the legal culture, see HA Tran, “An Assessment of the Vietnamese Land Law and Regulation” (1995) 13 Wisconsin International LJ 585 at 600-01
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the concept of private ownership of land has not taken root despite economic liberalisation. All land continues to be owned by the state.45 Ventures requiring the use of land obtain from the government “land-use rights.” By the grant of land-use rights, the state grants the entrepreneurs license to use the stipulated state land for the purposes specified in the license and for a specified period of time. At one time, there were real question over the legality of mortgaging these land-use rights; this issue has been somewhat resolved by regulations permitting local banks to obtain mortgages.46 While the Vietnamese government has made modifications to the law to allow for transferability of land-use rights, the transfer is invariably subject to approval by both the national government as well as the local government.47 In substance, therefore, there is no free alienability of land. Moreover, the license is tied to the particular use specified in the license. Any variation in the use of the land requires official government sanction.48 Indeed if the terms of the land-use license are violated, the state may revoke it. All these diminish the marketability of the land-use rights. Lenders to projects in countries like Vietnam continue to be most wary of the efficacy of security over land. It is therefore no surprise that these lenders require additional credit support before they are willing to participate in the loan package. Apart from examining the premises which support the value of land as a collateral, a lender taking a security interest over land should be also be careful to comply with the local law pertaining to “perfection” of his security interest. In Singapore and Malaysia, a lender taking mortgage of a company’s registered land needs to register with the relevant land registry49
46
47 48
49 50
Art 7(2) Ordinance on Rights and Obligations of Foreign Individuals and Organizations Leasing Land in Vietnam (14/10/94) Foreign lenders circumvented the problem somewhat by requiring the mortgage to be given to a Vietnamese bank which covenants to hold the benefit of the security for the benefit of the foreign lenders. However with the promulgation of new regulations in 1996, the legality of such a device is put in doubt. See Regulations on Mortgages and Pledges of Assets and Guarantees for Bank Loans (Promulgated with Decision 216-QD-NH1 dated 17/8/96). By Decree No 12-CP, all land use matters are the responsibility of the Provincial People’s Committees and the Vietnamese Party. See, eg, Art 6(2) Regulations on BOT Contracts (23/11/93): “... mortgaged rights and assets [must] continue to be employed in the implementation of the objectives of the project as stipulated in the BOT contract.” Singapore: s 45 Land Titles Act (Cap 157). Malaysia: s 206(1) and 243 National Land Code (Act 56 of 1965). Singapore: s 131(3)(e) Companies Act (Cap 50) Malaysia: s 108(3)(e) Companies Act 1965. The registration requirement applies to land belonging to the company wherever situated.
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as well as the companies registry;50 failure to do so results in his inability to assert his security against the liquidator and other creditors. In Indonesia, the deed necessary for the creation of hypothec has to be executed before a land deed officer.51 A legal issue which continues to cause not a little concern is whether such a deed executed before a notary public in a foreign jurisdiction is sufficient compliance with the requirements of Indonesian law.52 There are other factors which impair the value of real property as security. Squatters and sub-tenants may have occupancy rights which prevent the sale of the land with vacant possession. In Djakarta (Indonesia), for example, postwar regulations confer occupancy rights in buildings constructed before 1960 which severely affect the secured party’s right to sell these buildings with vacant possession.53 The due diligence process should anticipate these problems. (b) Security interest over movables The resale value to purchase price ratio of movables in a project finance varies with the type of asset involved. Raw materials can probably be sold at market value but used equipment tend to lose much of their original value. Used capital assets like manufacturing equipment, power generators and transport equipment, are likely to be sold at only a fraction of their original cost and are unlikely to permit recoupment of the loans advanced for their acquisition. Moreover, there is also normally a discount on the market value of used assets in a forced sale, whether the company is in liquidation or in receivership. Indeed some assets – like power cables and oil pipelines – though physically movable have practically no resale value. In these instances, the taking of security will largely be for defensive purposes. Different legal systems have different regimes for regulating the circumstances in which the security can be asserted against the liquidator and other creditors. Common lawyers term this perfection of the security interest.
51
Indonesian Civil Code ss 1171. The land deed officer is known locally as the “PPAT”. A notary may be a “PPAT”. 52 S Gautama, Indonesian Business Law (1995, Penerbit PT Citra Aditya Bakti, Bandung) pp 573-4. 53 See S Gautama, ibid, p 570.
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“Perfection” requirements safeguard the interests of other creditors. They should not be led to believe that the debtor has more assets than he actually does. They should be warned against prior security interests that the property may be subject to.54 Perfection requirements take the following two principal forms:55 (a) possession (b) registration and filing. Requiring the secured party to obtain possession of the movable property would often mean physical removal of the property out of the hands of the debtor. Other creditors dealing with the debtor are put on inquiry if a piece of property represented to form part of the unencumbered assets of the debtor are in the possession of a third party. They would or should therefore be extra vigilent in taking security interest over that piece of property. The pledge at common law is such a possessory security. However the common law also recognises the concept of constructive possession, ie, the property is legally deemed to be in the possession of a party even though physical control of the property remains in the hands of another. Thus the concept of attornment wherein the person presently having possession of the movable property intimates to the creditor that he holds the property to the creditor’s order forthwith.56 The creditor-pledgee may, without destroying the pledge, take possession of the goods or documents of title and release them to the debtor on a limited license to use the property as his trusteeagent.57 These doctrines permit the creditor to avoid the inconvenience of warehousing the movable property; it also has the advantage of not depriving the debtor of the use of the assets. Such sophistication of legal doctrine may not exist in less developed legal systems.58 Nonetheless each legal system
54
55
56 57 58
This is the raison d’etre of the Torrens system which aim to put place all interests over land on a register. This system originated in South Australia and has been copied in many jurisdictions including Singapore and Malaysia. Another form of perfection is notification. This is found in the common law governing assignment of choses in action. In an assignment of a chose in action (as in a debt), the assignee who does not notify the person against whom the chose is assertable loses his priority as against a subsequent assignee who gives notice. Dearle v Hall (1828) 3 Russ 1. Martin v Reid (1862) 11 CBNS 730; Meyerstein v Barber (1866) LR 2 CP 38; Dublin City Distillery v Doherty [1914] AC 823. North-Western Bank v Poyntes [1895] AC 56. Under Indonesian law, the pledge is destroyed if the goods pass into the possession of the pledgor with the consent of the pledgee. Civil Code Art 1153. Non-possessory security over movables can, however, be obtained by the use of “fiduciary transfer of ownership”. This device derives its existence not from the Civil Code but from Dutch jurisprudence. In fiduciary transfer of ownership, the debtor transfers his ownership rights to the creditor who leases it back to the debtor. No formalities are required. There is no statutory requirement for registration or execution before a notary public. See S Gautama, supra, note 52, at 607614.
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has its nuances and legal incidents associated with possessory security that may defeat the secured party’s expectations. Creditors dealing on the faith of goods in the possession of the debtor or his agents should not be caught unawares of such legal nuances which undermine the confidence that one can place on things in the possession of the debtor and his agents. A more effective means of notifying the world of encumbrances upon an asset is by requiring the registration or filing of the encumbrance. If the asset is substantial and susceptible to unique identification, a system based on registration against the asset is feasible. Alternatively, the registration system may be based on registration against the debtor; a check against the register would reveal to parties intending to deal with the debtor the encumbrances upon his assets and therefore a good view of his credit position. A rational registration system would provide a convenient “one-stop” shop for both registration and checking. That ideal, however, is seldom attained. There may be overlapping registration regimes governing a particular secured transaction, making it necessary for the secured party to register with multiple registries. Moreover, these different registration regimes may prescribe diverse formalities. These are matters which make it imperative for competent local counsel to be engaged. It may be possible, by astute structuring of the transaction, to avoid the registration requirements of a regime. The extent to which this is possible differs between different legal systems. In England, Singapore and Malaysia, purchase money security can be structured as a charge or in the form of title retention; the latter would avoid the registration requirements which the former would attract. Registration may also be avoided by structuring the instalment sale as a leasing transaction. What may in substance be a security interest may be structured in a form which avoids the registration requirements. The dispensation which a legal regime gives for form to prevail over substance depends as much on the particular provisions of the legislation as its jurisprudence and legal culture. A legal system that leans more toward substantive reasoning than formal reasoning will be more willing to penetrate the form to look at the substance.59 In common law countries, fixed and floating charges can be created against a company. Compared to the pledge, a charge is a much more convenient device. The chargor (debtor granting the charge) is entitled to remain in possession of the asset. In charging the asset to the chargee, he appropriates to the chargee the stipulated assets and grants to him rights over the assets in the event that he fails to pay the debt. The chargee’s interest over the
59
See MG Bridge, “Form, Substance and Innovation in Personal Property Security” [1992] JBL 1.
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asset is a proprietary one; it follows the asset even though it is transferred into the hands of a third party. Thus, a donee of a charged asset takes it subject to the interests of the chargee. Only a bona fide purchaser of the legal interest for value without notice takes the asset free of the chargee’s interests. Whether a charge is required to be registered in order to be effective against third parties depends on whether it falls within the provision governing the registration of charges; if it does not, the charge need not be registered. For this reason, a (fixed) charge over an insurance policy is not registrable in England, Australia, Singapore and Malaysia.60 The registration system found in England is not very rational. Neither are those of its offspring found in many of the Commonwealth countries. A rational system like that found in Article 9 of the US Uniform Commercial Code would require the registration of all security interests. Encumbrances upon a debtor’s assets can be checked conveniently. A nearly comprehensive registration regime while going a long way toward protecting the interests of third parties can also be fatally misleading to parties dealing on faith of its transparency without realizing its loopholes.61 Creditors have found the concept of the floating charge – a creation of the common law – an extremely convenient device. In contrast to the fixed charge which requires the chargee’s specific consent before the asset can be dealt with free of the encumbrance, the floating charge permits the chargor a general power to deal with the assets in the ordinary course of his business. It is thus ideal for a pool of assets which is constantly changing, eg, inventory, raw materials and receivables. New assets acquired by the chargor and falling within the terms of the instrument creating the floating charge become subject to the charge without the necessity of further documentation. Such is the utility of the floating charge that international lawyers invariably attempt to replicate it in foreign countries; if there is not an identical concept, they will try to construct a functional equivalent using the basic constructs found in local law. The nuances will be different – they will need to be investigated carefully lest the lender proceeds on the wrong premises regarding the legal incidences of the “floating charge” under local law. (c) Security interests over receivables
60
Under the corporations codes of these countries, a charge over an insurance policy is not a registrable interest. England: s 395 Companies Act 1985 . Australia: s 262(1) Corporations Law. Singapore: Companies Act (Cap 50) s 131(1). Malaysia: s 108(3) Companies Act 1965. Although a (fixed) charge over book debts is registrable, it was held in Paul & Frank Ltd v Discount Bank (Overseas) Ltd and Board of Trade [1967] Ch 348 that an interest in an insurance policy is not a book debt. 61 See recommendations for reform along the lines of the Art 9 Uniform Commercial Code in A L Diamond, A Review of Security Interests in Property (1989, HMSO, London).
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Expected cash-flows from revenue producing contracts with the project’s output purchasers can serve as valuable collateral for the project lender. In common law jurisdictions, the collateral can take a few forms.62 The borrower may mortgage the accounts receivable to the lender, ie, he assigns to the lender the right to receive the debt but reserves to himself the right to redeem the debt so assigned. Alternatively, he may charge the accounts receivable. In a charge, the chargee is not entitled to collect the debt or ask for the debt to be paid to him directly. There is a risk that the chargor may dissipate the moneys collected. There is also a risk that if the chargor pays the money into an overdrawn account, the chargee will be unable to claim against the bank.63 The expected cashflow may also be used as a credit enhancer in another way; the borrower may assign the debt in an out and out sale but issue a guarantee for the payment of the debt. Although the assignment coupled with the guarantee is not a legal security stricto sensu, it performs the function of a security. The advantage of structuring the credit enhancement device in this manner lies in the avoidance of the registration requirements under the companies legislation of many countries inspired by the English model.64 How good a security is the assignment of a debt? The payment obligation constitutes the debtor’s end of the bargain with the creditor under an executory contract. There may be various circumstances under which the law excuses the payment debtor from his obligation to pay. Very often, the law construes
62
For a comprehensive treatment of the legal aspects of accounts receivables financing, see Oditah, Legal Aspects of Receivables Financing (1991, Sweet & Maxwell). For a more concise discussion, see Goode, Legal Problems of Credit and Security (2nd ed, 1988, Sweet & Maxwell) Chap V. 63 Much turns on whether the bank receives the money with notice of the chargee’s interest. The bank who receives with notice is liable. If the bank receives the money without notice, it is not liable to account for the moneys had and received to the extent that it has given value for it; the bank is taken to have given value to the extent that the moneys paid in were applied to reduce the assignor’s overdraft. Thomson v Clydesdale Bank Ltd [1893] AC 282, Coleman v Bucks and Oxon Union Bank [1897] 2 Ch 243. This problem is avoided in a legal assignment of a debt in that notice is given to the debtor. 64 For criticism of the existing English regime and recommendations for reform, see Crowther Committee Report (Cmnd 4596, 1971, HMSO) para 5.7.20 et seq, Cork Committee Report (Cmnd 8558, 1981, HMSO), Diamond Report, supra, note 61, para 8.24 et seq. 65 Bolton v Mahadeva [1972] 1 WLR 1009 (installation of defective central heating system prevented the supplier from suing for any part of the contract price). See also Sumpter v Hedges [1898] 1 QB 673 (in an ‘entire’ contract, conferment of partial benefit does not entitle the giver to sue for the value of the benefit conferred unless the benefit is voluntarily accepted by the receiver.)
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the payment-debtor’s obligation to be conditional on the payment-creditor performing his end of the bargain in a satisfactory manner.65 In common law sales, the seller’s non-performance would excuse the buyer from his obligation to pay; indeed it would provide the buyer cause to discharge himself from all further obligations under the contract.66 Even if the seller’s breach does not entitle the buyer to discharge himself from his obligation to pay, the buyer has a right to damages which he may set up against the assignee, whether or not he has notice of the assignment.67 The value of the assignee’s security in the payment obligation is thus diminished by the extent to which the payment debtor may, by reason of the payment-creditor’s breach, be excused from making payment. Lenders should therefore acquaint themselves fully with the terms of the contract so that they can appraise themselves of the risk that they are undertaking. The legal device which the lender can use to enhance the value of his security is to require the output purchaser’s payment obligation to be structured as an independant obligation vis-à-vis the performance obligation. As the efficacy of the security depends on the defeasibility of the payment obligation, the manner in which the payment obligation is drafted is all important. If an independent covenant is intended, it should be clear that the output purchaser is obliged to pay whether or not the output is delivered. He should also covenant not to raise against the assignee counterclaims and defences which he would otherwise be able to raise against the assignor of the debt. The lender would then be entitled to sue for payment notwithstanding the non-delivery or defective delivery of the output required by the output purchaser. The take-or-pay contracts and throughput contracts earlier mentioned are structured upon the notion of independant covenants. The legal efficacy of these indirect guarantees is only as good as the drafting. Frustration/force majeure. The project may be affected by external events which radically change the ability of a contracting party to perform what he has promised. The waters feeding a dam may be diverted by the country further upstream making the continuance of the project futile. Raw material required for the manufacturing process may become impossible to obtain because of a worldwide shortage. Is the output purchaser still bound to
66
Distinction is made between commercial contracts where time of delivery is presumed to be of the essence, and non-commercial contracts where time is not so presumed. In a commercial contract, the performance-debtor’s failure to perform by the time stipulated in the contract would entitle the performance-creditor the right to discharge himself from the contract. Hartley v Hymans [1920] 3 KB 475. 67 Graham v Johnson (1869) LR 8 Eq 36; William Pickersgill & Sons Ltd v London & Provincial Marine Insurance Co Ltd [1912] 3 KB 614; The Raven [1980] 2 Lloyd’s Rep 266.
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his independant covenant to pay notwithstanding there being no further expectation of receiving what he contracted for? Is the supplier of the raw material liable for failing to deliver? The impact of such external contingencies is covered in common law by the doctrine of frustration. In civil law, they are dealt with under the doctrines of force majeure and cause etrangere. The effect of a particular contingency on the contract varies from one legal system to another because different legal systems hold the pacta sunt servanda principle to different degrees of strictness. To constitute a event of force majeure under French law, the event must be unforeseeable,68 irresistible and external to the obligor. The English formulation of frustration is couched in comparatively more liberal terms: it must render the contract illegal, impossible or radically different from what was in the contemplation of the parties at the time the contract was entered into. In a Singapore case,69 the compulsory acquisition of a piece of land by the Government was held to be a frustrating event notwithstanding that the powers were exercised under a notorious piece of legislation; the purchaser of the land was discharged from his obligation to pay the purchase price. The foreseeability of the compulsory acquisition would prevent its constituting an event of force majeure under French law. Even if these related doctrines under the different legal systems consider the supervening event sufficient cause to relieve the obligor of his obligations, they may take effect differently. At common law frustration discharges the parties from their contract pro tanto; the recovery of deposits and suit for benefits conferred are largely determined by the provisions of the Frustrated Contracts Act.70 A party seeking the annulment of a contract under French law is required to apply to court for an annulment order.71 The court does not necessarily annul the contract or terminate it; it may suspend the performance
68
In the opinion of the (French) cour de cassation: Whereas if the irresistibility of an event is in itself alone constitutive of force majeure when its prediction does not permit one to avoid its effects, this is not so when the debtor may normally foresee such an event at the time of entering into the contract. (Cass. Civ. 1re 7 March 1966 JCP 1966 II 14878). Cited in P Marshall, Comparative Contract Law (1994, Gower, Hampshire, England) p 335 Philippine civil law takes a similar approach. See Civil Code of the Philippines Art 1174. See also Arturo Tolentino, Commentaries and Jurisprudence on the Civil Code of the Phililppines (Central Lawbook Publishing Co, Quezon City) vol 4 p 126 et seq. 69 Lim Kim Som v Sheriffa Taiba [1994] 1 SLR 393. 70 UK: Law Reform (Frustrated Contracts) Act 1943. This statute has been widely copied throughout the Commonwealth. See, eg, Singapore – Frustrated Contracts Act Cap 115. 71 Art 1184 Code Civil. If the court annuls the contract retroactively, the parties are required to return any benefits received. If the contract is terminated, the parties are entitled to retain the benefits received.
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if it views the event to be a temporary one. From the perspective of the lender, the prospect of the output purchaser being discharged from his payment obligation diminishes the value of the debt assigned to him. For this reason, lenders require the insertion of a hell-or-highwater clause in which the payment-debtor binds himself to pay notwithstanding the occurrence of certain listed contingencies; the listed contingencies may consist of events which the governing law would otherwise regard as sufficient cause for discharge of the payment-debtor’s obligations. Such express stipulations are likely to be given effect to by the courts. Doctrines like frustration and force majeure can be seen as the legal system’s mechanism for allocating actualized unforeseen and unprovided for risks. Where the parties have expressly provided for the effects of certain contingencies, the party autonomy principle should prevail. Thus unless there are public policy objections, the terms of the hell-and-highwater clause should be enforceable. Moral hazard risk. Thus far we have discussed the lawful excuses which prevent the payment-creditor from suing on the debt. One must also be mindful that in an executory contract, the payment-creditor bears a moral hazard risk – the payment-debtor may fail to perform without a lawful excuse. The payment-creditor and his assignee will have to pursue legal remedies against the payment-debtor. The nature of the legal remedies available depend on both the substantive law governing their relationship inter se and the procedural law of the forum in which the dispute resolution is carried out. Whether the judgment-debtor has a lawful excuse to the suit is a matter of substantive law; creditors would want to choose for the supply contract a governing law which they are familiar with and in which they have confidence. The ease with which the payment-debtor may be sued differs from jurisdiction to jurisdiction. Whether summary judgment may be obtained is a matter for procedure; it will depend on the forum in which the dispute resolution is carried out. To a certain extent, the moral hazard risk may be reduced by a careful choice of the governing law. Choosing the law of an established legal system to govern the contract avoids the doctrinal uncertainties of a less mature legal system. The parties would also plan for a dispute resolution mechanism which is reliable and a forum which affords them the desired dispute settlement procedure. For this reason, arbitration is often chosen as the mode for settlement of disputes as the parties can determine the arbitrators; more importantly an arbitral award
72
New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards.
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rendered in a country party to the New York Convention72 can be enforced in another country which is also party to the Convention. 3. Summary of legal issues which should be addressed in taking security over project assets in a cross-border project finance Cross-border project finance requires the project counsel to traverse the different paradigms found in the diverse legal systems with which the project finance is connected. The concerns which he should have in mind have been discussed above. For the purpose of summary, they may be grouped into the following five areas: (a) Assets over which security interests can be taken. What exactly does the borrower own? Is his interest over the asset a proprietary one which can be freely transferred? Or is his interest more in the nature of a license, ie, he is granted a right to use which may be revoked and which becomes valueless once the terms of the license are breached? Is there any value in taking a security interest over a license? Is it legally permissible to take a security interest over the license?73 Are there any peculiar legal restrictions which inhibit the foreign borrower’s ability to take a security interest over the asset? Is it legally possible to take security interest over future property? Types of security interests. What are the kinds of security interests that can be created against the different project assets? Is it possible to create a floating charge or its functional equivalent under local law? What are the priority rules affecting the security interests? Does the local law prescribe any creditors who are preferred over a secured creditor? Execution against the secured property. How may execution against the secured property be effected? Is the lender permitted to appoint a receiver? What is the extent of the lender’s liability for the receiver’s actions? If a sale of the secured property is to be carried out, what are the legal rules governing the sale?
(b)
(c)
73
In Taiwan, the Statute for Encouragement of Private Sector Participation in Transportation Infrastructure prohibits assignment of the concession or the creation of security interests over the project assets. See Cassingham et al, supra, note 10, at 267. This should be contrasted with the franchise granted to Hong Kong Air Cargo Terminals Limited to build and manage air cargo facilities at Super Terminal 1 of Chek Lap Kok Airport; to enable the franchisee to obtain financing, the franchisee was permitted to assign its franchise rights to lenders who would take over the management of Super Terminal 1 in the event of its failure to operate.
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Is it to be by a judicial sale, a public auction or some method unfamiliar to the lender? (d) Issues pertaining to perfection of the security interest. What steps need to be taken to ensure that the security taken is effective against other creditors and the liquidator of the debtor? What are the formalities to be complied with? In a syndicated or club loan involving sharing of security, are there legal devices similar to the trust concept which allow for beneficiaries of the pool of security interests to be changed from time to time without the necessity of fresh documentation? Private international law issues. What governing law should be chosen for the output sales contract and the assignment? What problems can arise if the output purchase contract is governed by the law of Country A and its assignment by the law of Country B? Does the jurisdiction where the payment-debtor is located permit a foreign law to govern the assignment of the debt?
(e)
E. ENDNOTE
Project finance is best conceptualised as a kind of limited recourse financing. The project sponsor is able to insulate himself from the risk of project failure but lenders would invariably require guarantees and other credit support from the project sponsor in order to be confident about the project sponsor’s commitment to the project. The equity risk must in the end analysis rest with the project sponsor. Nonetheless it remains true that the lenders assume greater risk compared to a normal fully collateralized loan. The risks that attend a project will need to be identified and dealt with. Some of the risks can be reduced. Others can be isolated and borne by willng parties. The role of legal instruments and devices in accomplishing risk reduction and risk spreading cannot be understated. As the efficacy of these instruments and devices vary according to the effect given to them by different jurisdictions, their effect in the jurisdictions in which their enforcement may be sought needs to be investigated. Such legal risks should also be clearly identified and borne in mind. It is one thing to be faced with the consequences of a risk which one has assumed consciously. It is another to be afflicted with a risk which is foreseeable but unplanned for.
*
LLB (Hons) LLM (Columbia); Advocate & Solicitor (Singapore); Lecturer, Faculty of Law, ALEXANDER F H LOKE* National University of Singapore.
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