What Is Project Finance Law?
Project finance law refers broadly to the field of law that relates to the creation and maintenance of entities that exist to finance the development of new projects. The most visible area involves what is commonly referred to in the industry as "project finance," a rather specific type of financing that was designed to finance large, complex construction projects. However, a growing number of energy companies are using long-term repowering projects as an effective replacement for traditional mergers and acquisitions.
In its simplest terms, project finance offers a way to structure a financial transaction so that a debt investment in a project takes substantially no risk. Under this scheme, a lender takes a risk when the project investment is made, but, once the funds are put to use, the investment is secured by assets in which the borrower has no equity stake.
In the context of "project finance," the lender takes a complete look at each of the project’s components so that each is left to stand independently of the debt in order to hedge against the defaults of other components, often allowing lenders to lend in a 50-to-70 percent range with a guaranteed rate of return.
Under these terms, lenders take no risk once the funds are disbursed, and may be repaid a combination of cash and stock. In effect, the lenders of the project are then guaranteed a set level of return, and on a set level and schedule of payouts.
There are a number of legal issues that must be addressed up front with these types of transactions, including the treatment of existing construction debt and development loans , as well as the setting of contract terms and rates for all primary components of the deal for the duration of the term.
The primary mechanics of project finance law involve the creation of a limited liability company that will own a new plant, in which the owners contribute equity and third-party investors contribute debt. The debt holders promise repayment of loans through cash flow generated by the sale of power and other products, which are sold under separate agreements.
As one of the most important aspects of project finance law, the question of whether or not to create a single specialized entity to handle the project is often complicated by the fact that many lenders prefer an established corporation as a parent that can issue bonds or stocks in order to offer more structure and depth to the deal.
While the structures of project finance law vary on a case-by-case basis, many of them involve the creation of a special purpose corporation or special purpose entity both as a way to limit liability and risk and to provide smooth financing plans as the primary structure for all business units involved.
This rather convoluted arrangement can be further complicated by the fact that, under a typical project finance law framework, there is often no recourse to the general partners if the entity defaults on its debts. In other words, there is no opportunity to gain equity in the project’s tangible assets or in its intellectual property fund.
All of these different negotiation points make project financing especially difficult to navigate without the guidance of a legal professional experienced in project finance law.
The Legal Principles Behind Project Finance
Project financing is governed primarily by the common law principles of contract. In the context of a project finance transaction, the typical legal framework consists of a set of complex, interrelated contracts which outline the relationships between the parties that are involved in the project. The agreements and documents which make up a typical project finance deal include the loan, equity, and security agreements; a concession agreement between the government and the company (if the project were completed under a government concession); any subcontracts; and asset ownership agreements. The complexity and sophistication of such agreements are meant to give a sense of security to shareholders and investors (debt or equity) in the project.
The legal validity of project finance can be traced back to certain well-established principles in English contract law. These principles include: the concept of freedom to contract; enforceability of contracts; the doctrine of when and how a party may terminate a contract for breach (default); limitation (or exclusion) of liability; interpretation (construction) of contracts; and enforcing the obligations of a contract.
It is important to note the distinction between a contract and a covenant. Contracts generally arise from an act or transaction by which a party agrees to perform an obligation in return for some benefit, whereas a covenant is a restriction or requirement on an obligation. Covenants are often contained in deeds and mortgage documents.
Those Who Make Project Finance Happen
A project finance transaction is typically comprised of the following five major groups of parties: The sponsors or project companies are typically private sector ("private sector" is used throughout this blog to refer to investments other than those by the national government, even though in sovereign countries such as Papua New Guinea they could literally be the only players in a deal) equity investors and may include the contractors and/or other subsidiaries and affiliates of the contractors as potential equity providers.
Lenders are typically commercial banks or development banks that specialize in project financing and invest direct equity or preferred shares by way of subordinated debt instruments or the equity quasi-equity convertible instruments referred to above. For large projects, Lenders may include a syndicate of several commercial banks and/or development banks. Contractors are usually developers and/or operators with experience in the relevant industry or trade or providers of goods and services to the Project. The sponsors or/or project company, as the case may be, will, depending on the nature of the project, available credit support, guarantees and other factors, employ contractors to carry out construction, installation and commissioning and will usually contract with a builder and/or operator as relevant on a long term basis to construct, operate and/or maintain the project. In order to carry out its activities it will usually employ suppliers and/or subcontractors.
Managing Risk in Project Finance
Within the realm of project finance law, risk management assumes paramount importance. Financial transactions and legal agreements rest on assumptions about the financial, social, and political landscape. Under these conditions, accurate projections regarding those aspects are critical. To the extent that such projections are inaccurate, the financial structures of projects become deficient. Project finance techniques can help mitigate the following types of risk: Estimating the appropriate value of a project is one of the most difficult aspects of project financing. Valuation occurs at the outset, prior to negotiations over prices. The development of flexible, rigorous techniques to track risk that accompany a project is essential. For example, a database can capture cost estimates and the contingencies involved, which allows for a menu of options to decrease risk. Impeccable record-keeping is necessary for these options to be viable. Some risks begin as contractual obligations. One way to avoid these risks and make ultimate liability less onerous is to transfer risk to another party or parties to the contract or project (e.g., subcontractors, senior lenders). Less frequently, buyers can be persuaded to assume risk. However, ensuring that mutual obligations are coordinated into the terms of the contract is essential.
Project Finance Forms and Models
Project finance transactions commonly take the form of non-recourse or limited recourse financing. With non-recourse financing, lenders’ repayment of their loans is secured entirely by a pledge of the project’s assets and revenues, so that the project itself is the source that generates sufficient cash flow to enable debt service under the loan agreement. Under such financing, there is no recourse to the project’s equity owners for repayment of the loan in the event of a payment default. Limited recourse loan documents contain guarantees by equity owners of minimum necessary debt service on the loan through scheduled distributions of the project borrowers’ cash flows. When the project borrower cannot make such scheduled distributions, this gap may be bridged under the loan documents by requiring the project borrower to obtain supplementary equity contributions from its equity owners to make up any shortfalls in the scheduled distributions.
In other words, while equity owners of project borrowers are not automatically responsible under the project’s loan documents to make good on the project borrower’s payment obligations , they do commit in advance to providing supplemental equity infusions that would be necessary to maintain appropriate levels of distributions to the project borrower’s lenders in the event of certain negative events or poor economic performance during the term of the loan. Projects that employ a limited recourse structure are sometimes so-called "bank project financings" and provide greater comfort to lenders than what would be associated with a project borrower reliant solely on its own cash flow to make all debt service payments.
Because lenders look to the project’s assets and cash flow for repayment of secured debt under a project lending transaction, it may be necessary in practice to employ interest rate hedging arrangements and currency hedges (when a project borrower is subject to payment obligations under its debt instruments in a foreign currency) to maintain a balance between cash flow coming from the project’s assets prior to debt service and interest rate risk and currency fluctuation risks that come from the project’s capital structure and projected cash flow stream.
In a typical power project, for example, project lenders’ loan documents may require the seller under a long-term energy sale agreement (which is used to monetize a project borrower’s future cash flow from a scheduled agreed upon stream of energy sales) to pledge its rights under the energy sale agreement for the benefit of those project lenders, and to enter into interest rate hedging arrangements to lock in interest rates for any interest payments due under such long term agreement.
Examples of Successful Project Finance Transactions
Project finance has been utilized in a multitude of sectors across the globe, with success on a variety of levels. Some well-known examples of project finance include the Channel Tunnel Project between England and France, upgrading of the Panama Canal to accommodate larger ships, the railway lines and expansions in both Australia and the United Kingdom, the construction of highways, airports, and general infrastructure projects. The development of renewable energy has also turned out to be an increasingly popular use of project finance.
One popular use of project finance is an expansion at the Los Angeles International Airport called the Tom Bradley International Terminal. The project included multi-phase improvements to modernize the airport and upgrade public transportation connections. In December 2015, the City of Los Angeles’s Board of Airport Commissioners approved the construction management work and development agreement for the project. As part of funding the expansion, Los Angeles World Airports marketed nearly $1.4 billion in four bond issuances.
In 2007, Kiewit International Inc. developed a project called Christopher B. Burke Engineering Arlington Road/I-65 Construction Management. This project was an indicator of a positive trend in public-private partnerships between private and public entities within Indiana. The project consisted of constructing bridge girders for the new Interstate 65 over Arlington Avenue project. The Indiana Department of Transportation awarded the contract to Kiewit in November 2007.
The United States Virgin Islands Water and Power Authority contracted with Fluence Solutions, LLC, in 2018 to construct the largest reverse osmosis desalination plant in the Caribbean. Financing for the $57 million project consisted of loans from the Government of the Virgin Islands and a private loan from EverBank. Detailed analysis of the financial and legal aspects of the project’s structuring, financing, and documentation resulted in one of the most financially and legally complex developments of its kind. The project included investor-friendly legislation that provided a level of assurance pertaining to the U.S. Virgin Islands’ utility laws, especially regarding the method of recovery for the costs associated with developing the desalination project. The contract was structured as an engineering, procurement and construction contract with the authority responsible for overseeing monitoring and testing, and the contractor responsible for the overall project development.
The government of Palau and a subsidiary of the Pacific Rim Group, Palau Power Authority, executed a loan agreement in 2018 for a multimillion-dollar upgrade and expansion of water storage facilities on Palau’s largest island, Babeldaob. The Recovery Zone Economic Development Bond program, the 2009 Recovery Act, provided the approximately $5.6 million loan.
Developments in Project Finance Law
The landscape of project finance law is constantly evolving, with recent trends pointing to a greater focus on infrastructure needs, new financing structures, and a growing emphasis on sustainability and social-impact investing. Infrastructure development, particularly in Asia and Latin America, is predicted to be a major component of project finance deals in the future, with increased investment from both public and private sectors. This trend is being propelled by governments and municipalities recognizing the necessity of modern infrastructure to boost their economies and attract foreign investments. Further pushing the edge in project finance law are the emergence of innovative financing structures, such as green bonds and brownfield financing. Green bonds are a newer financing option that has rapidly gained traction, as they allow for the development of eco-friendly projects, while bringing in investors who are socially conscious. Brownfield financing is another trend that has emerged, which provides capital for the redevelopment of previously developed land. The U.S., such as with the Veterans Affairs Department, has also seen the implementation of this structure in financing and developing brownfield sites. These emerging financing structures have been pivotal in addressing an array of project developments that, in years prior, never made it past the drawing board. The significant increase in socially responsible and impact investing over the past decade has also forced project finance law to adapt to this growingly important field, as project developers are looking to include socially responsible aspects in their deals . One example includes the use of gender equality legislation for empowerment purposes in African nations seeking to develop their infrastructure. Additionally, the modernization of infrastructure in rural communities has become of increasing importance, as more projects are looking to improve the living quality of their workers and community members. The re-emergence of certain markets is resulting in a renaissance of project finance as well, such as with Russia. A country typically avoided by many investors due to its recent history of heightened sanctions and economic instability, Russia has become a hotbed of project finance activity, particularly in energy. This year, Russia’s finance minister indicated that the government was "open to completely new ideas," and that it was seeking more partnerships with foreign investors, a pivot that has intrigued many investors. Lastly, project finance law is poised to be affected by the anticipated legislative changes in the next U.S. presidential election cycle. Many project finance investors have voiced concerns regarding the effects of potential changes in the political climate. On November 6, significant changes were put in place by the Democrats winning the House. However, key areas that will undoubtedly see changes are the taxes and international trade policies, which could greatly affect project finance law in the coming years. With an impending "battle" of interests, investors are bracing themselves to see how project finance deals are going to respond to these changes.