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Project finance is difficult to definebut easy to recognize; it generallyinvolves lending significant

amounts of money to a thinly capitalizedcompany whose primary assets consist ofcontracts and licens-es, but that is wherethe simplicity ends.Notwithstanding theefforts of variousgovernments tostandardize privatefinance initiative(PFI) and similardocumentation, thefield defies theapplication of fixedrules. The range ofassets financed, fromunderground minesto overhead cables, and the breadth ofjurisdictions covered, from Canada toMozambique, mean that even the most

basic rules must flex to meet the facts andissues in question. In the absence of rigidmarket standards and agreed form docu-ments, the project finance lawyer mustpatiently assess the economic, technical,

political and legalrisks presented byeach project anddraw on experi-ence to help theparties reach aworkable consen-sus in face ofoften uniquechallenges.

The disciplineis old. Some datethe onset of thepractice to thefinancing of the

Panama Canal over a century ago. Thebig mining deals in Africa and LatinAmerica of the 1960s and 1970s are per-

haps a more realistic grounding for thefield, and the development of independ-ent power projects in the US after the1978-1979 oil crisis gave rise to themodel for many of our modern projects.Recent years have seen this model usedin an ever-broadening range of coun-tries. Although projects lawyers areclustered in London, New York andHong Kong, as the application of proj-ect finance has spread, they are nowfound in almost every city where com-plex transactions are documented.

Twenty years ago, debate raged overwhether non-recourse (project) lendingviolated the regulations that requiredcommercial banks to limit themselves to“prudent banking practices”. Morerecently, focus has been placed on theextent to which capital reserve require-ments should be increased on projectloans in accordance with the Basel IIaccord. The decades have shown thatrestructurings are common (perhaps dueto the pervasive covenants imposed onborrowers), but losses have been relative-ly rare. Nonetheless, the idea thatrecourse on a loan should be limited toa special purpose borrower and its assetsremains a focus of attention.

This has not, however, stemmed theflow of project finance deals. Theworld’s rising demand for energy andnatural resources, driven in large part bythe remarkable growth in the Chineseand Indian economies, has led to a rapidgrowth of investment in resource extrac-tion projects. With prices at recordlevels, international oil companies areexploring for energy in remote parts ofWest Africa, the Caspian and theMiddle East, and the resulting projectsoften entail billions of dollars of capitalcosts. Many of the host countries havenever seen financing, or even commer-cial, transactions on this scale. At thesame time, a number of more developedcountries have used these techniques tobroaden the participation of the privatesector in traditional public sector activi-ties, ranging from utilities to roads,hospitals, schools and prisons. Althoughthe underlying commercial law is settledin these countries, public/private part-nerships have often required broadreforms of regulatory regimes to accom-modate them. Thus, as project financehas moved into new areas, the legalissues have become more challenging.

The joy of the covenantIn the most basic terms, project financeis a form of secured lending. Much of the

Project finance

Rules for negotiatingproject finance deals

Phillip Fletcher explains the art of negotiating an international projectfinancing to achieve consensus in the absence of set rules

The most common dispute theprojects lawyer encounters isover the terms and enforceabilityof long-term so-called take orpay contracts

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legal expertise is drawn from the disci-pline of banking. One who sees thebeauty of the perfect covenant, the joy ofan all-encompassing event of default orthe elegance of a multi-tiered intercredi-tor agreement has the capacity to excel inthe field. But the inclination to do socomes from never having outgrown thewish to play with big toys. Like assetfinance lawyers, the projects lawyer needsto know how to take security, fixed orfloating, over every asset imaginable, butthey must also understand how theunderlying facility operates and its abilityto generate revenues for periods encom-passing decades.

Legal analysis is but one element ofthe project finance due diligence effort.Technical advisers assess the physicalplant, marketadvisers predict theavailability andcost of inputs andthe value of thefuture revenuestreams, and modelauditors assess theintegrity of thefinancial models.The lawyer workswith these otherexperts to identifyrisks and to gener-ate an integrated due diligence report -often stated to be limited to legal issues,but out of necessity based heavily oncontributions from a variety of experts.Out of this process the parties are askedto assess the “bankability” of a potentialrisk or the project as a whole.

That no project is the same should beapparent. Variables such as the robust-ness of the underlying economics, oftentested by reference to anticipated debtservice coverage ratios, the degree ofcomplexity and reliability of the asset’stechnology and the stability and trans-parency of the host country’s politicaland legal environment, determine howaccommodating investors are likely to bein relation to legal and other risks.

Take or payWhat are the legal issues a projectslawyer deals with in making these assess-ments? Few legal disciplines are notrelevant. Projects lawyers use all of theskills learned in law school, bar (onehopes) criminal procedure; the law ofcontracts, property, trust, torts and equi-ty feature regularly in their practice. Asthe financing instruments range frombank loans and capital markets instru-

ments to political risk insurance fromofficial credit agencies and a variety ofShari’a compliant instruments issued byIslamic institutions, they must be able todocument the differing requirements of awide range of markets. In fact, theirexpertise must extend far beyond financepapers: the best among them are able toact from the inception of a project as itprogresses from negotiating its construc-tion contracts to the day it issues aprospectus for a public issue of securities.The more modest will confess that theyare merely adept at deploying the expert-ise of their firm across this broad rangeof requirements.

The most common dispute the proj-ects lawyer encounters is over the termsand enforceability of long-term so-called

take or pay con-tracts. Thesecontracts, in alltheir permuta-tions, underpinmost big projects.The sale ofpower, of oil andgas, naturalresources,telecommunica-tions capacityand a range ofother products is

generally framed in a contract in whichthe purchaser agrees to take a minimumlevel of output at a price based on someform of set formula for a specified peri-od. The project company is thuscontractually insulated, at least to somedegree, from the one thing it can leastcontrol: long term market conditions.

Minimum volume commitments canbe particularly burdensome on the buyerwhen they are matched by a fixed orfloor price on those volumes. If you tryto sell 8¢ output in what has become a2¢ market, before long the purchaserwill try to find a way out of the deal.The claim could be disingenuous: “wedidn’t understand what the deal wasabout”. It could be mysterious: “the con-tract was entered into only because youbribed our government”. It might evenappear reasonable: “we can’t take theoutput because a hurricane blew awayour transmission grid”. It might also beon the basis of defences at law: “we arebroke, we can’t pay and the court saysyou can’t make us”. Or in equity: “it’sunfair to make us pay this much overthe market”. There are court decisions inmany jurisdictions addressing a broadrange of such circumstances. The deci-

sions turn on the facts of the case, theterms of the underlying agreements andthe environment in which the dispute isheard.

Risk assessmentThe role of the project finance lawyer isto seek to bring some advance certaintyto this process by identifying the funda-mental risks and getting the parties toagree who assumes them long before theyarise. They focus the parties’ attention onthe worst case scenarios, thereby makingthem consider circumstances none ofthem wishes ever to encounter. There israrely any debate about the effect of anact of God (most of which can beinsured), but when the discussion turnsto who takes the risk of an act of govern-ment, such as the imposition of a newtax or an import restriction, any of whichmight change the fundamental econom-ics of the deal, the debate can be heated.No party can easily assume a risk that isbeyond its control, and governmentsrarely reassure parties that such risks willnot arise, as they generally do not wish tofetter the discretion of their successors.Whether there are price re-openers toaddress unanticipated shifts in marketconditions can also be controversial.

These issues became heated during thecrisis that hit many developing countriesin the late 1990s. Currency devaluationcaused the cost of debt denominated indollars, and the price of goods and serv-ices acquired in dollars, to sky-rocket inlocal terms. Electric utility companies,paying for power and fuel in dollars,simply could not pass on the cost tolocal consumers whose incomes were setin local currency. Every defence imagi-nable emerged, along with notabledisasters, such as the failure of Enron’sDabhol project in India, and more rea-soned restructuring of power projects inPakistan and Indonesia. Each of thesehad capital costs well in excess of $1 bil-lion and thus attracted considerableattention. In the successful restructur-ings, lenders rescheduled debt, sponsorsaccepted lower returns and the tariff wasconsequently reduced, but perhaps moreimportantly (and quite unintentionally),the process took so long that the localeconomies had time to recover and thetariffs again became affordable. In thefailed Dabhol project, amidst allegationsof abuse of the original negotiatingprocess, construction halted and theasset was left to rust, with only the liti-gating attorneys being the winners.

These crises hit not only developing

Project finance

Having spent years as insolvencypractitioners, projects lawyersare today working on floats,trade sales and other exits fromthese now successful investments

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economies. In late 2002, the collapse oflarge power traders such as TXU Europeand Enron, among others, left much ofthe UK power generation sector insol-vent. Banks assumed de facto ownershipover much of the industry. A few yearslater (as power prices have recovered)the defaulted loans are trading back atpar, and many banks (or the hedgefunds they sold to) have recovered addi-tional, unanticipated equity value.Having spent years as insolvency practi-tioners, projects lawyers are todayworking on floats, trade sales and otherexits from these now successful invest-ments.

London or New York?A second area of regular focus is inrespect of the selection of governing law.Sometimes the issue is limited to thechoice of the law governing the loanagreement, generally as between Englishor New York law. The preference is per-haps less substantive than meets the eyeas much of the case law in those jurisdic-tions on the enforceability of customaryfinance agreements comes to similar con-clusions. The debate can nonetheless beheated in the “battle of the preferredforms”. The corresponding choice offorum for dispute resolution is, however,perhaps more interesting, as a variety ofparties have a preference to litigate ineither London or New York and not theother.

But the question can have real sub-stance as well. Let us take the case of anatural gas products project in a WestAfrican country. The off-take contracts,in the form of a forward purchase offuture production, were between theWest African producer and an offshorespecial purpose company incorporatedin Bermuda. The Bermuda companyborrowed loans to finance the purchaseof the products from the producer; itthen on-sold those products to pur-chasers worldwide and used the proceedsof those on-sales to service the loans.The financing documents were governedby New York law and the project’s bankaccounts were charged to the lendersunder English law in London. The gov-erning law of the off-take contract couldreasonably have been chosen by refer-ence to any of these jurisdictions. Thechoice could have affected fundamentalissues, including the circumstances inwhich title to the future productioneffectively passed from seller to buyerand the enforceability of liquidateddamages for breach. Where should dis-

putes be heard? What law will the forumapply and will the result differ as aresult? Will judgments or awards beenforced in the home jurisdiction of theassets, the borrower or the other projectparties? A decision focused merely on apreference for a familiar law or forumcould miss the changes in legal resultthat might turnon these choices.

The importanceof the choice oflaw or forummight be evenmore acute whenthe country inwhich the projectis located eitherhas no tradition ofreported case lawor where domesticlaw, is, say, basedon Shari’a principles that prohibit suchfundamental elements of the transactionas the charging of interest on loans. Insome cases, a choice of foreign law and aselection of a neutral forum might behelpful even if enforcing an offshorejudgment back in the host country islikely to be challenging. In other cases,it might make better sense to structurethe transaction to conform to Shari’aprinciples than hope for enforcement ofa non-Islamic transaction.

Creating security in a barrenlandA third area of regular challenge is struc-turing security packages, often acrossjurisdictions and over diverse assets. Alender’s collateral package serves two pur-poses: it allows the lender to deprive theborrower of the pledged assets when theloan is in default and it assures the lenderthat no other creditor is able to takethose assets in preference to it. The avail-ability of such packages have generallygiven lenders the confidence to extendlong-term, (relatively) low-cost loans.Where an asset is located in a countrywith no filing or registration code, orwhere the enforceability of contractualstep-in rights granted to lenders is uncer-tain, the challenges are considerable. Inaddition, some countries charge high feesfor the registration of security, but oftenwithout providing certainty that suchsecurity can be enforced. In such cases,the lenders are often asked to do withoutthe traditional security package and areasked to rely solely on pledges of offshorebank accounts, assignment of export con-tracts and, in some cases, security over

shares. A notable debate arose in the context

of projects being developed in a MiddleEastern jurisdiction that lacks both acode governing the registration of secu-rity and even a basic insolvency law.Early projects sought creative means toallow lenders some form of security over

hard assets.Solutions extend-ed to effecting anoffshore condi-tional sale of theassets. When thestructure was putthrough the dis-closure of a publiccapital marketsissuance, the cor-responding riskfactor caused suchfocus on the

uncertainty of the regime that theunderwriters concluded it best to dowithout that form of collateral security.Without legislative change (which mightbe forthcoming), subsequent deals havealso done without. Perhaps this isbecause the underlying economics of theprojects are sufficiently robust to allowcompromise on these issues. Security,however, remains a vital element ofweaker transactions in other countries.

The financing of satellite projectspresents similar challenges. Who wouldwant to foreclose on a satellite orbitingthe earth 35,000 kilometers above theequator? More to the point, becausespace is beyond the jurisdiction of indi-vidual states, where would one registerthe interest? Treaties have addressed howto register security over aircraft andships, which by their nature can operatein numerous jurisdictions. But no inter-national convention exists (though oneis being formulated by Unidroit, theRome-based International Institute forthe Unification of Private Law) for thetaking of security over objects in space.

This has not prevented satellites frombeing project financed. While the singlemost valuable item might be beyond thephysical grasp of secured creditors, care-ful structuring has allowed creditorsconstructively to repossess satellites bytaking assignments of operating agree-ments and licenses (where permissible),revenue-generating customer contractsand in-orbit insurance.

Ecological considerationsBack on earth, an area of increasing focusis environmental and social planning.

Project finance

Who would want to foreclose ona satellite orbiting the earth35,000 kilometres above theequator?

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Local environmental legislation mightsimply not exist in some jurisdictions,but projects financed by national ormultinational credit institutions oftenhave to comply with World Bank or sim-ilar standards. These require thecomprehensive mitigation of environ-mental emissions and management of theproject’s impact onlocal populations.A wide variety ofnon-governmentalorganizations(NGOs) have pres-sured leadingcommercial banksinto accepting sim-ilar standards. Theadoption of the so-called EquatorPrinciples by thesebanks has nowlargely aligned their requirements withthose of the World Bank. As a result, bigprojects generally have to meet standardsthat far exceed those that would berequired by domestic law in the hostcountry. Lenders have in effect assumedthe role of the absent global environmen-tal regulator.

Troubled watersA host of other challenges arise whenprojects encounter difficulties. For exam-ple, in a project in Florida, a change ofgovernor led to an investigation of thelegitimacy of the project’s environmentalpermit. Unfortunately, this occurred partway through construction. A reasonabledecision would have been to suspendfunding under the $650 million debtfacility. However, this would have causedthe virtual write-off of the outstandingdisbursements; there is little value in ahalf completed plant. The decision tocontinue funding and complete the proj-ect while seeking to negotiate asettlement with the environmentalauthorities required, at a minimum,nerve. Two tranches of senior lenders(commercial banks and insurance compa-nies) and a syndicate of subordinatedlenders had to reach that decision inde-pendently, and the constructioncontractor had to agree to complete theproject without increasing its pricedespite incurring cost from delays andthe uncertain circumstances. Even moreremarkably, the original sponsor (an oth-erwise well known and successfulcompany) had to recognize that it wasnow unwelcome in Florida and agree tosell (at a loss) its project to an untainted

third party developer. Had the intercredi-tor relationships and security packageaddressed all of this? No. But were therules at least enough to define the proce-dures by which the parties would have toreach settlement? Yes. Had any party notshown maturity and judgment, all wouldhave been lost.

The Gulf warsgave rise to similarissues. Faced witha deterioratingenvironment inthe region, lenderswere reviewingcarefully materialadverse changeconditions in bothunderwriting andcredit agreements.In some cases, thecondition was

clear, in others not, however, the regionas a whole responded in a consideredmanner, deferring closing dates whereappropriate, accommodating price flexwhen needed and, more structurally,host governments agreed to absorb a cer-tain degree of the risk associated withterrorism or war. As a result, few proj-ects were disrupted and since then themarket has flourished.

More than a lawyerAgainst this mosaic of issues, the role ofthe project finance lawyer is not limitedto answering specific legal questions, butextends also to organizing the processand setting priorities for what must beachieved. Negotiations take place amongnumerous parties. Each has an interest inthe deal, but each interest is limited bythe scope of the role and the anticipatedbenefits to be derived. Ask too much ofany party, and they will be deterred fromparticipating; ask too little and the over-all viability and security of the projectmight be brought into question. A con-cession made to one party, for examplegoing without the requirement for theprovision of a completion guarantee,might simply impose burdens on anoth-er. Such a concession could, for example,necessitate the provision by the contrac-tor of enhanced performance warranties,or the agreement of the off-taker toaccept delays in the development sched-ule or an increased tariff if constructionproblems emerge. Trade-offs of this sortmust be negotiated across legal traditionsand even languages. The success of thelargest projects, where the sources of debtfinance might encompass export credit

agencies in Asia, Europe and NorthAmerica, in coordination with multilater-al institutions, such as the World Bank,commercial bank lenders in London,Tokyo or New York, and perhaps region-al finance institutions based in (say)Dubai or Johannesburg, is dependent onthe project finance lawyer’s ability to helpthe parties reach a workable consensus.

Recognizing who has negotiatingleverage in this context is perhaps moreart than science. Broadly stated, as glob-al financial liquidity has grown and asofficial credit agencies have placed ahigh priority on encouraging globaldiversity of energy sources, sponsors andeven host governments have gained theupper hand. The process adopted bygovernments of competitively tenderingthe opportunity to develop a project,and of sponsors in turn tendering theopportunity to finance it, has allowedthe sponsor market to gain enhancedleverage over financial institutions.However, projects must still meet thebenchmark of bankability and the proj-ects lawyer is often called upon to helpform a view as to whether they do.Allowing negotiating leverage to flow asthe market demands, but preserving theessence of the credit, is the art of thedeal.

Phillip Fletcher is a partner at MilbankTweed Hadley & McCloy LLP in Londonand is a member of IFLR’s editorial board

Project finance

Recognizing who has negotiating leverage in thiscontext is perhaps more art thanscience