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In previous updates we have referred to the need to make project documentation bankable. This is because the majority of large scale infrastructure projects will be project financed. Therefore, it is useful to consider what is meant by bankability and, in particular, what are some of the basic requirements for making project documentation bankable.
A bankable contract means a contract which satisfies the requirements of lenders. The question is therefore what are the lenders' requirements? Whilst this will be similar to the requirements for the sponsors, those requirements are not identical. Lenders will be more risk averse than sponsors. This is mainly because the lenders will not have the upside on a successful project in the same way as sponsors whereas they are exposed to the downside if a project is unsuccessful. As a result, lenders have a different risk:reward ratio. Accordingly, they will be willing to bear less risk than the sponsors.
The less comfortable the lenders are with the risk allocation the greater amount of equity support the sponsors will have to provide. In addition, lenders will have to be satisfied as to the technical risk. Price is also a consideration but that is usually considered separately to the bankability of the contracts themselves because prices go more directly to the bankability of the project as whole.
As a general rule, the project company must bear as few risks as possible. The lenders' requirements vary from project to project and jurisdiction to jurisdiction. It cannot be stated with absolute certainty that a certain risk allocation will definitely be bankable although it can usually be stated which allocation will not be bankable. Therefore, it is possible to set out the general requirements for bankability and to discuss what, for the majority of projects, represents the optimal position.
Before discussing bankability in more detail, it is helpful to briefly explain what is meant by project financed projects. Project financing is a generic term that refers to financing secured only by the assets of the project itself. Therefore, the revenue generated by the project must be sufficient to support the financing. Project financing is also often referred to as either "non-recourse" financing or "limited recourse" financing.
The terms "non-recourse" and "limited recourse" are often used interchangeably, however, they mean different things. Non-recourse means there is no recourse to the sponsors at all and limited recourse means, as the name suggests, there is limited recourse to the sponsors. The recourse is limited both in terms of when it can occur and how much the sponsors are forced to contribute. In practice, true non-recourse financing is rare. In most projects, the sponsors will be obliged to contribute additional equity in certain defined situations.
Bankability - General
This update discusses bankability of project documentation. However, it is also useful to discuss the basic framework of the financing documentation and what, as between the lenders and the project company, will be required to make a project bankable.
In the financing documentation the lenders will:
- not accept change of law risk - this is often a difficult issue for project companies undertaking projects in Asia and often means political risk insurance must be obtained;
- not accept risk of discriminatory or project specific taxation;
- not permit distributions to be paid to sponsors unless and until debt service has commenced and even when debt service has commenced payment of distributions will depend on meeting and maintaining coverage ratios;
- require the project company to bear only those risks under the project documentation which it is fair and reasonable for the project company to bear and which it can reasonably be expected to be able to manage; and
- require the sponsors to adequately capitalise the project company and to provide a sufficient proportion of the total project cost - usually between 20% to 40%.
Bankability of the Concession Agreement
The acceptable risk allocation in the concession agreement will, to some extent, depend on the ability of the project company to flow risks down to its contractors eg: the EPC contractor, the O&M contractor and, if there is a separate offtaker, the offtaker.
As discussed above, lenders will not normally accept any change of law risk. This is particularly relevant in the context of the concession agreement where the counterparty is a government entity and in a position to influence changes of law. Therefore, the concession agreement should make provision to amend the terms of the concession if there is a change in law which adversely effects the return earned by the project company. In the context of PFI/PPP projects there is a relatively sophisticated mechanism for achieving this. However, it does mean the project company will usually bear a portion of the change of law risk, at least for the periods between benchmarking exercises.
Given the financial model will be based on earning revenue throughout the entire concession period, the concession agreement should make provision for the concession to be extended if a force majeure event occurs or if the concession is suspended by the government. The lenders' interest in these two issues will depend both on the term of the concession and the repayment schedule for the debt.
If the concession agreement is terminated (other than for the project company's default) the project company must be entitled to, as a minimum, receive an amount equal to all the outstanding debt. Ideally, the project company should also be paid an amount equal to the amount necessary to close down the project. From the sponsors' perspective the project company should also receive the profit it would have earned if the concession agreement had not been terminated.
Bankability of the Construction Contract
The optimum position for lenders in respect of the construction contract is:
- a turnkey contract which provides a single point of responsibility for all aspects of the design, engineering, procurement, construction, commissioning and testing of the facility;
- a fixed price with no ability to vary the contract price;
- a fixed completion date supported by uncapped liquidated damages payable for late completion;
- limited ability to claim extensions of time, basically only for project company caused delay and for defined force majeure events and even then the contractor should only be granted an extension of time if it meets certain pre-requisites in respect of time for submission of claims and information that must be provided to support a claim;
- performance guarantees (for operating facilities like power stations and process plants) supported by uncapped liquidated damages payable if the performance guarantees are not met; and
- unlimited liability of the contractor.
It is highly unlikely that any contractor would agree to sign a construction contract containing terms like those described above. Therefore, the lenders will compromise. The issues on which they may compromise will depend on the nature and location of the project. However, generally speaking, lenders will accept:
- caps on liability; and
- an ability to vary the contract price if delays occur, if variations or suspension are ordered, if a change of law occurs and in some circumstances if unexpected site conditions are discovered.
The lenders will also want the applicable risks imposed on the project company under the concession agreement to be flowed down to the contractor. In particular, risks like completion dates, level of performance and liquidated damages amounts must be flowed down.
Bankability of the Fuel Supply Agreement
The project company will ordinarily have far less bargaining strength in respect of the fuel supply than in respect of most of the other agreements. As a result, lenders are forced to take a more pragmatic view of their wish list. Nonetheless, there are some issues the lenders will focus on.
- security of supply - the lenders will require certainty that the project company will be able to procure enough fuel to operate without interruption and they will want the fuel supplier to be liable if the fuel supply is interrupted. This issue relates not only to the fuel supply agreement itself but also to the ability of the project company to source alternative supplies; and
- take or pay obligations - ideally the lenders would prefer a take and pay obligation. If there is a take or pay obligation the lenders will want to ensure that the project company has a reasonable level of protection against being made to pay for fuel it cannot use. For example, the project company should be able to cease paying for fuel if force majeure events occur. Force majeure should normally be defined as broadly as possible. However, that broad definition presents risks of its own because it will derogate from the security of supply.
Bankability of the Offtake Agreement
The lenders' requirements will depend on the type of project being financed. For example, the lenders will be much more prescriptive in respect of their requirements for a long term power purchase agreement ("PPA") than they will for an offtake agreement for urea produced at an ammonia/urea facility because in the case of the ammonia/urea facility the urea is an internationally traded commodity. Therefore, the project company is a price taker with no real ability to negotiate price independently of the market, whereas under a PPA the project company is a price setter with an ability to negotiate price and other terms directly with the offtaker.
However, in either case there are certain provisions the lenders will require:
- a take or pay obligation - the offtaker should be obliged to pay for the product regardless of whether or not they take delivery. Even if there is a take or pay clause in an offtake agreement for a process plant there is still the issue of where to store the physical product. Once the storage area is full, and assuming the project company cannot find alternative buyers, the facility will have to be shutdown. Ideally, the offtaker should bear the cost of the shutdown and restart;
- a currency pass through - the project company should not bear the foreign exchange risk - the basic rule that income should be in the same currency as the debt applies; and
- the purchaser to assume much of the force majeure risk.
Bankability of the O&M Contract
In the case of the O&M contract the interests of the project company and the lenders are closely aligned. The lenders and the project company will both want the operator's remuneration linked to performance. This means bonuses if production targets are exceeded (whilst at the same time operating the facility safely and within all the operating limits) and damages if production targets are not met.
The performance targets should be linked to the performance levels reached during the construction contractor's performance testing.
Conclusion
The above is only a snapshot of the bankability issues which will need to be examined in more detail in each project together with project specific issues.
If you need legal advice on the issues raised above,please contact:
HONG KONG
Damian McNair
T +852 2848 4646
F +852 2868 0124
damian.mcnair@mallesons.com
David Bateson
T +852 2848 4673
F +852 2537 1340
david.bateson@mallesons.com
AUSTRALIA
Jim Delkousis
T +61 3 9643 4109
F +61 3 9643 5999
jim.delkousis@mallesons.com
Geoff Wood
T +61 2 9296 2169
F +61 2 9296 3999
geoff.wood@mallesons.com
All Asian Projects and Construction Updates can be found at http://www.mallesons.com/our_firm/5501753W-09.htm