Key issues for lenders in project finance agreements

There are various elements of a project that will be of concern to the lenders who are financing it. In every case, there will always be an optimal position that is best for the lenders.

You may wish to refer to our separate Out-Law Introduction to project finance documents for further information and an explanation of some of the key terms used in this Guide. As a reminder, we will refer to the private sector company or partner created for the sole purpose of owning the project as 'Projectco', and the contracting local authority entering into the agreement with Projectco as the 'Authority'.

Consents

The optimum position for the lenders in relation to the consents and authorisations required before a project can be worked on or completed is as follows:

• all consents should be issued for the duration of the project;
• the terms of the consents should not be subject to much variation by regulators;
• the consents should not be terminated if the lenders have to enforce their security, and can be transferred to a purchaser from the lenders following any enforcement; and
• the permits should be fully transferrable.

How the lenders feel about relaxing any of the above conditions will depend on the track record of the various regulators and issuing authorities involved. In addition, it may be possible to pass the risk of not obtaining or renewing a consent or a change to that consent's terms and conditions on to another party. This could be done at the project agreement stage.

Shareholders' agreements and sponsors' equity contributions

The optimum position for the lenders is:

• the sponsors should provide all of their equity contributions up front;
• the sponsors should provide cover for the cost of the project overrunning;
• the sponsors should provide cover for any gaps in insurance coverage.

It may be acceptable for the sponsors to pay in their equity contributions over time or even to back-end those contributions, or pay them after the project is completed, as long as the lenders are happy with the creditworthiness of those sponsors. Those sponsors could also provide some form of credit enhancement to the lenders for additional security, for example a bank letter of credit.

It is unlikely that the sponsors will be happy to cover any gaps in insurance coverage. Although this is the optimum position for the lenders, in practice the party most likely to be required to perform the role of insurer as a last resort is the Authority. It may also be possible to structure the project finance document around any problems caused by insurance gaps.

The project agreement

The optimum position for the lenders in respect of the project agreement itself is as follows:

• the terms of the concession should be fixed for the life of the project;
• there should not be any unduly onerous or difficult terms imposed on Projectco;
• the Authority should accept the risk of any changes in the law. It will be difficult for the lenders to accept that Projectco should carry this risk, and if this is the case they should make enquiries into how any actual expenditure brought about by such a change in the law is to be funded or reduced;
• the concession period should be extended by any period of 'force majeure', or burdensome events that occur outside of the control of the parties;
• the concession should not be terminated simply because the lenders enforce their security;
• the arrangements for termination of the concession, where this is permitted, should not be deprive Projectco of their rights and any compensation to which Projectco is entitled should always be sufficient to repay the lenders;
• on an enforcement, the lenders should be able to freely transfer the concession to a third party.

The lenders may be prepared to accept more onerous terms in a concession agreement, as long as the project company is able to pass a fair degree of the risk involved through to other contracting parties with acceptable creditworthiness.

The deal struck on compensation for termination for reasons other than default by Projectco is usually that the compensation should be sufficient to repay debt and equity, and ideally to provide some return to equity investors. Debt in these cases should include any additional sums Projectco may have to pay on the early termination of any other arrangements.

The Authority may seek to have deducted from the compensation it needs to pay Projectco on termination any amounts already credited to Projectco's bank accounts and any equity committed by the sponsors but not yet injected into Projectco. This should be acceptable, provided the lenders have security over Projectco's bank accounts and the sponsors' equity injection undertakings.

Lenders will usually reluctantly accept that, where the project covered by the finance arrangement is of national importance, the person granting the concession has a veto over the identity of the person it is granting that concession to. It is sometimes possible to limit such a person's control to their satisfaction with the technical and financial capability of the person proposed.

The construction contracts

The lenders' ideal position for the construction contract is as follows:

• the construction contracts should be turnkey, meaning that the construction contractor is responsible for all aspects of the construction and design of the project output;
• there should be a fixed price, incapable of being readjusted, and that price should be paid in one lump sum on completion;
• completion must occur within a fixed time period;
• the events that could be considered 'force majeure' should be limited;
• where there is a concession agreement the contractor should only be able to claim force majeure, an increase in price or an extension of completion time to the extent that Projectco is able to claim the same under the concession agreement. In addition, completion under the construction contract can only occur when completion also occurs under the concession agreement;
• liquidated, financial damages should be payable if completion is not achieved by a fixed date and those liquidated damages should be adequate and at least cover interest payable on the loan for a reasonable period;
• there should be no contract administrator or engineer, but rather an employer's agent instead - this person would be an agent of Projectco and made subject to the restrictions contained in the project credit agreement;
• there should be no – or, at least, no large - limits on the contractor's liability;
• the contractors should give extensive guarantees and, if the contractor is to be released from liability for defects after a certain period has passed, that period should be long and only begin running after a well-defined completion test has been passed.

All of the above is seldom achieved.

The lenders may be satisfied with a project management approach to construction so long as they receive technical advice on all aspects of the design and works covered by the individual construction contracts, and are persuaded that the overall position with regard to limits on liability, liquid damages and warranties is acceptable.

Lenders will accept that a lump sum payment really is unobtainable and that the construction contract may instead come with staggered payments, providing these are made on sensible milestones being achieved or by reference to the value of the work done and as long as some price retention or a performance bond is included.

Lenders will normally accept the construction period being extended for force majeure, and for certain other risks. However, lenders tend to dislike wide force majeure clauses and will normally, for example, expect a contractor to take responsibility for his own workforce in terms of something like industrial action affecting the works. Sometimes the lenders will go further and request that a general provision be included in the construction contract stating that the contractor can only claim from Projectco what Projectco itself is able to claim and actually receives from the person granting the concession.

The operation and maintenance agreement

Where the operation and maintenance agreement is concerned, the optimum position for the lenders is the same as that of Projectco and is as follows:

• the operator should be given proper incentive to run the project properly and efficiently;
• the operator should be subject to penalties if certain operating targets are not met;
• the lenders should be able to remove – or bring about the removal of – the operator for poor performance;
• the lenders will expect penalties to occur at a point comfortably above that which puts repayment of their loans in jeopardy;
• the lenders should be allowed some control of the dismissal of an operator for poor performance through the termination rights that Projectco has under the operation and maintenance element of the project agreement.

Lender's security concerns

The lenders' main legal concerns on the underlying contracts are likely to be:

• ensuring that they can take effective security over the contracts; and
• ensuring that all the key contracts remain in place in one form or another if and when they enforce that security.

The project agreement is generally not assignable or chargeable without the other party's consent and, if such consent is not forthcoming, then the most that can be obtained is a charge on the proceeds of the contract.

The second point is usually dealt with by way of direct agreements. For more information, see our forthcoming Out-Law Guide to Direct Agreements with project lenders.