Project Finance

Introduction

Origins of project financing

With the explosion of project financing in the late 1980s and 1990s, both in Europe and around the rest of the world, there is a temptation to think that the financing of projects on limited or non-recourse terms is a relatively novel concept, and one for which the ingenious lawyers and bankers of the 1980s can take most of the credit. This is, however, far from being true. Indeed, there is early evidence of project financing techniques being actively used during Roman times and earlier still. According to the historians, sea voyages on the Mediterranean ocean were extremely dangerous adventures in Greek and Roman times, mostly on account of the dual perils of storms and pirates. As a result of these nautical perils, some risk averse merchants would take out a fenus nauticum (sea loan) with a local lender in order to share with that lender the risk of a particular voyage. The fenus nauticum worked on the basis that the loan was advanced to the merchant for the purpose of purchasing goods on the outward voyage, which loan would be repayable out of the proceeds of the sale of these goods (or more likely other goods bought overseas with these proceeds). If the ship did not arrive safely at the home port with the cargo in question on board, then according to the terms of the fenus nauticum, the loan was not repayable. At the time, this was viewed essentially as a form of marine insurance, but it can just as easily be classified as an early form of limited recourse lending, with the lender assuming the risk of the high seas and the perils that accompanied her. History also recounts that, in order to protect their interests, these brave lenders would often send one of their slaves on the voyage to ensure that the merchant was not tempted to cheat on the lender (an early ancestor of the security trustee perhaps!).

In modern times too there is plenty of evidence of project financing techniques being used by lenders to finance projects around the world. In the 19th century, lenders in the City of London were financing numerous railway and other projects in South America and India and investing in other overseas ventures that had many features of modern-day limited recourse lending. In most cases these loans were not specifically structured as limited recourse loans as we know them today, but the commercial reality was that this is exactly what they were.

However, limited recourse lending in the UK really took off in the early 1970s when lenders in the UK started making project finance available for the development of some of the early oil and gas fields in the UK continental shelf. The early projects that were financed on this basis were relatively few and far between as there was a relatively small pool of lenders prepared to finance projects on this basis. It would also be true to say that the treasurers of many of the companies operating in the UK continental shelf at this time took some time to appreciate the advantages of financing projects in this way. The first major financing in the North Sea was in the early 1970s. This was British Petroleum’s Forties Field, which raised about £1 billion by way of a forward purchase agreement (see section 4.7 for a description of this structure). Shortly after this transaction two loans were raised by licence holders in the Piper Field (Occidental Petroleum Corporation and the International Thompson Organisation). Other financings of North Sea hydrocarbon assets followed and by the late 1970s and early 1980s what had started as a modest number of transactions had turned into a significant volume of project financings related to oil and gas fields, first in the UK continental shelf and then in the Danish and Norwegian continental shelves.

Much of the documentation and many of the techniques for these early oil and gas transactions were borrowed from practice in the US where adventurous bankers had been lending against oil and gas assets for many years. The significant difference in the context of the North Sea, however, was that bankers were in reality taking significantly more risks in lending against oil and gas assets in the North Sea. Not only were these brave bankers lending against offshore oil and gas assets where the risks were considerably greater (especially in the early days, given the new technology being developed and utilised), but they were also, in some cases, assuming all or part of the development/completion risk. Traditionally, in the early days of project financing in the US, loans were agreed against producing onshore assets, which carried a far lesser degree of risk. The North Sea was, however, an altogether more hostile and hazardous environment.

The 1980s in the UK saw perhaps the greatest growth spurt in project financing, with power projects, infrastructure projects, transportation projects and, at the end of that decade, telecommunications projects leading the way. This was continued throughout the 1990s until the more recent global financial crisis, which saw a huge growth in project financing, not only in Europe and the US but also throughout Southeast Asia and further afield.

Definition of project finance

There is no universally accepted definition of project finance. A typical definition of project financing might be: “The financing of the development or exploitation of a right, natural resource or other asset where the bulk of the financing is to be provided by way of debt and is to be repaid principally out of the assets being financed and their revenues.”

Other more sophisticated definitions are used for special purposes; set out at Fig. 1 is an example of a definition used in a corporate bond issue. This illustrates the aims of the bondholders, on the one hand, to exclude from the definition any borrowings having a recourse element (since the purpose of the definition was to exclude project finance borrowings from the bond’s cross-default and negative pledge) whilst, on the other hand, the aim of the issuer to catch as wide a range of project-related borrowings.

Extent of recourse

The expressions “non-recourse finance” and “limited recourse finance” are often used interchangeably with the term “project finance”. In strict terms, non-recourse finance is extremely rare and in most project finance transactions there is some (limited) recourse back to the borrower/sponsor beyond the assets that are being financed. As will be seen in section 6, this security may amount to full or partial completion guarantees, undertakings to cover cost overruns or other degrees of support (or comfort) made available by the sponsors/shareholders or others to the lenders.

It may even be that the only tangible form of support that a lender receives over and above the project assets is a right to rescind the project loan agreement with the borrower and/or to claim damages for breach of any undertakings, representations or warranties given by the borrower in the project loan agreement. Of course, where the borrower is a special purpose vehicle with no assets other than the project assets being financed by the lenders, then a right to claim damages from the borrower is likely to add little to a claim by the lenders for recovery of the project loan from the borrower. Further, the right to rescind the project loan agreement is likely merely to duplicate the acceleration rights of the lenders following the occurrence of an event of default contained in the project loan agreement. However, in those cases where the borrower does have other assets, or the sponsors are prepared to underwrite any claims by the project lenders for damages against the borrower, then a claim for damages for breach of any undertakings, representations or warranties may afford the lenders some additional recourse.

A claim for damages, however, from a lender’s perspective is not the same under English law (and for that matter most common law based jurisdictions) as a claim for recovery of a debt under, say, a financial guarantee. This is because a claim for damages is subject to certain common law rules; for example:

• The lender must show that the loss was caused by the breach in question
• This loss must have been reasonably foreseeable at the time the undertaking or warranty was given
• The lender is in any event under a duty to mitigate its loss.

In other words, a claim for damages against the borrower is an unliquidated claim as opposed to a claim for a debt, which would be a liquidated claim. All that a lender has to show in the case of a liquidated claim is that the debt was incurred or assumed by the borrower and that it has become due. This is clearly considerably easier than having to satisfy the common law rules and, consequently, lenders and their advisers, wherever possible, will seek to structure arrangements with a view to acquiring liquidated claims against borrowers and others supporting the borrower’s obligations (this is particularly important for lenders in the context of sponsor completion undertakings – see section 6.5).

One of the key differences, therefore, between project financing and corporate financing lies in the recourse that the lender has to the assets of the borrower. As the earlier definitions demonstrate, in project financing this recourse is limited to an identifiable pool of assets, whereas in corporate financing the lender will have recourse to all the assets of the borrower (to the extent that these assets have not been charged to other lenders). Indeed, should the borrower fail to pay a debt when due, then, subject to the terms of the loan documentation, the lender would be entitled to petition to wind up the borrower and prove in the liquidation of the borrower on a pari passu basis with all the other unsecured creditors of the borrower. In the context of a project financing, however, a lender would only be entitled to this ultimate sanction if the project vehicle is a special purpose vehicle set up specially for the project being financed. In those cases where the project vehicle undertook other activities, then it would look to ring fence the assets associated with these activities and in these cases the lender would not ordinarily be entitled to petition to wind up the borrower for non-payment of the project debt. To allow otherwise would be to allow the lender to have recourse to non-project assets, which would defeat the purpose of structuring the loan on limited or non-recourse terms in the first place.

This principle of limited recourse financing was recognised by the English courts as long ago as 1877 (and possibly earlier) in the well-known case of Williams v. Hathaway (1877) 6 CH D 544. In this case, a sum of money (the fund) was paid by way of recompense by a railway company to the vicar of a parish and the incumbent of an ecclesiastical district in accordance with an Act of Parliament which authorised the railway company to take a certain church for its purposes. The Act directed, in effect, that the money be applied by the recipients to provide a new church and parsonage. The recipients of the fund contracted with a builder to build the church and parsonage and the project proceeded. In the event, the cost of the works exceeded the monies in the fund and the builder took legal action to recover the deficiency. Jessel MR, held, inter alia, that it was permissible for a proviso to a covenant to pay to limit the personal liability under the covenant to pay without destroying it. Despite the fact that the contractual arrangements were with the individuals who were for the time being trustees of the fund, it was held that “the object [of the contractual instrument] is to bind the fund” and not the trustees in their personal capacity.

Why choose project finance?

Before examining how projects are structured and financed, it is worth asking why sponsors choose project finance to fund their projects. Project finance is invariably more expensive than raising corporate funding. Also, and importantly, it takes considerably more time to organise and involves a considerable dedication of management time and expertise in implementing, monitoring and administering the loan during the life of the project. There must, therefore, be compelling reasons for sponsors to choose this route for financing a particular project.

The following are some of the more obvious reasons why project finance might be chosen:

• The sponsors may want to insulate themselves from both the project debt and the risk of any failure of the project
• A desire on the part of sponsors not to have to consolidate the project’s debt on to their own balance sheets. This will, of course, depend on the particular accounting and/or legal requirements applicable to each sponsor. However, with the trend these days in many countries for a company’s balance sheet to reflect substance over form, this is likely to become less of a reason for sponsors to select project finance (the implementation in the UK of the recent accounting standard on “Reporting the Substance of Transactions” (FRS 5) is an example of this trend)
• There may be a genuine desire on the part of the sponsors to share some of the risk in a large project with others. It may be that in the case of some smaller companies their balance sheets are simply not strong enough to raise the necessary finance to invest in a project on their own and the only way in which they can raise the necessary finance is on a project financing basis
• A sponsor may be constrained in its ability to borrow the necessary funds for the project, either through financial covenants in its corporate loan documentation or borrowing restrictions in its statutes
• Where a sponsor is investing in a project with others on a joint venture basis, it can be extremely difficult to agree a risk-sharing basis for investment acceptable to all the co-sponsors. In such a case, investing through a special purpose vehicle on a limited recourse basis can have significant attractions

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• There may be tax advantages (e.g. in the form of tax holidays or other tax concessions) in a particular jurisdiction that make financing a project in a particular way very attractive to the sponsors
• Legislation in particular jurisdictions may indirectly force the sponsors to follow the project finance route (e.g. where a locally incorporated vehicle must be set up to own the project’s assets).

This is not an exhaustive list, but it is likely that one or more of these reasons will feature in the minds of sponsors which have elected to finance a project on limited recourse terms. Project finance, therefore, has many attractions for sponsors. It also has attractions for the host government. These might include the following:

• Attraction of foreign investment
• Acquisition of foreign skills and know-how
• Reduction of public sector borrowing requirement by relying on foreign or private funding of projects
• Possibility of developing what might otherwise be non-priority projects
• Education and training for local workforce.

Structuring the project vehicle

One of the first, and most important, issues that the project sponsors will face in deciding how to finance a particular project will be how to invest in, and fund, the project. There are a number of different structures available to sponsors for this purpose. The most common structures used are:

• A joint venture or other similar unincorporated association
• A partnership
• A limited partnership
• An incorporated body, such as a limited company (probably the most common).

Of these structures the joint venture and limited company structure are the most universally used.

A joint venture is a purely contractual arrangement pursuant to which a number of entities pursue a joint business activity. Each party will bring to the project not only its particular expertise but will be responsible for funding its own share of project costs, whether from its own revenues or an outside source. Practical difficulties may arise as there is no single project entity to acquire or own assets or employ personnel, but this is usually overcome by appointing one of the parties as operator or manager, with a greater degree of overall responsibility for the management and operation of the project. This is the most common structure used in the financing of oil and gas projects in the UK continental shelf. Partnerships are, like joint ventures, relatively simple to create and operate but, in many jurisdictions, partnership legislation imposes additional duties on the partners, some of which (such as the duty to act in the utmost good faith) cannot be excluded by agreement. Liability is unlimited other than for the limited partners in a limited partnership, but these are essentially “sleeping” partners who provide project capital and are excluded from involvement in the project on behalf of the firm.

In many cases it will not be convenient (or may not be possible) for the project assets to be held directly (whether by an operator or the individual sponsors) and in these cases it may be appropriate to establish a company or other vehicle which will hold the project assets and become the borrowing vehicle for the project. The sponsors will hold the shares in this company or other vehicle in agreed proportions. In most cases where this route is followed, the company or other vehicle would be a special purpose vehicle established exclusively for the purposes of the project and the use of the special purpose vehicle for any purposes unconnected with the project in question will be published. In addition to the constitutional documents establishing the vehicle, the terms on which it is to be owned and operated will be set out in a sponsors’ or shareholders’ agreement.

Whether sponsors follow the joint venture (direct investment) route or the special purpose vehicle (indirect investment) route ultimately will depend on a number of legal, tax, accounting and regulatory issues, both in the home country of each of the sponsors and in the host country of the project (and, perhaps, other relevant jurisdictions). Some of the relevant influencing factors might include the following:

• A wish on the part of the project sponsors to isolate the project (and, therefore, distance themselves from it) in a special purpose vehicle. If the project should subsequently fail, the lenders will have no recourse to the sponsors, other than in respect of any completion or other guarantees given by the sponsors (see section 6.5 for an explanation of such guarantees). The sponsors are effectively limiting their exposure to the project to the value of the equity and/or subordinated debt that they have contributed to the project
• The use of a joint venture or partnership, as opposed to a special purpose vehicle, can often mean that the sponsors must assume joint and several liability when contracting with third parties on behalf of the joint venture or partnership. If the borrowing for the project is through the joint venture or partnership, this is likely to result in each sponsor having to show the full amount of the project debt on its balance sheet, not a particularly attractive proposition for most project sponsors.
• By contrast, the use of a special purpose vehicle may mean that the sponsors do not have to consolidate the project debt into their own balance sheets (if it is not a “subsidiary” or “subsidiary undertaking” or equivalent). This may also be important for cross-default purposes for the sponsor. A sponsor would not want a default by a project company (even if it is a subsidiary) to trigger a cross-default in respect of other contracts or projects at sponsor level. The corporate lenders to the sponsor may agree to this, provided there is no recourse by the project’s lenders to the sponsor in the event of a project company default, eliminating the risk that the project company default will damage or further damage the sponsor’s balance sheet (note the wide definition of “project finance borrowing” used earlier in this section that typically might be used in such a case)
• On a similar note, negative pledge covenants in a sponsor’s corporate loan documentation may prohibit or limit the sponsor from creating the necessary security required in connection with a project financing. As with the cross-default clause, the corporate lenders to the sponsor may agree to exclude security interests created by the sponsor (or a subsidiary or subsidiary undertaking of the sponsor) in connection with a specific project from the terms of the sponsor’s negative pledge
• It may be a host government requirement that any foreign investment is channelled through a local company, particularly where the granting of a concession might be involved. This may be for regulatory or tax reasons or, in the case of a strategically important industry, for security or policy reasons
• The use of a joint venture or partnership can have significant tax advantages in some jurisdictions (e.g. each participant may be taxed individually and may have the ability to take all tax losses on to its own balance sheet) which may make such a vehicle attractive for some sponsors. On the other hand, a limited liability company’s profits are in effect taxed twice, once in the hands of the company and again in the hands of the individual shareholders
• A special purpose vehicle will be attractive where different sponsors require to fund their investment in the project in different ways (e.g. one may want to borrow whilst others may wish to fund the investment from internal company sources) or one may want to subscribe equity whereas another might wish to contribute debt as well (e.g. subordinate the repayment of this debt to the right of project lenders) and
• Practical considerations may also be relevant. Partnerships and contractual joint ventures are less complicated (and cheaper) to establish and operate. Registration requirements in respect of limited companies and limited partnerships eliminate confidentiality. It should also be remembered that it is easier for a company to grant security, in particular floating charges, and this may be an important consideration for the raising of finance.

In the event, the choice will never be a straightforward one and it is often the case that sponsors will have conflicting requirements. This will be one of the many challenges for those involved in project financing. It is, however, important to establish the appropriate vehicle at the outset as it can be difficult to change the vehicle once the project proceeds and, especially, once the funding structure is in place.

Key sponsor issues

Having settled on the structure of the project vehicle, it will then be necessary for the sponsors to agree at an early stage on a number of other key matters. These will include:

• The respective roles in the project of each sponsor (e.g. who will deal with the technical aspects of the project, negotiate the concession, negotiate with the lenders, arrange the project insurances, negotiate with suppliers/offtakers, oversee the establishment of the project vehicle, arrange for the necessary consents and permits). Frequently the allocation of such tasks will have been dictated already in the make-up of the sponsor group, but it is important for each sponsor to have a clear understanding at an early stage of what tasks it is to perform
• The appointment of advisers to the project. The two key appointments will be the appointment of financial and legal advisers to the project. However, other advisers, such as technical, insurance, environmental and market risk advisers, may also be required, depending on the circumstances of a particular project
• The capitalisation of the project or project company. How much capital will be put in, when will this be injected and by what method? There is no hard-and-fast rule for determining how much sponsor capital must be injected into a project. Some projects have been structured on the basis that the sponsors have put up only a nominal amount of capital (called “pinpoint capital”). More typically, however, one might expect to see an overall debt/equity ratio in the 90/10 to 75/25, range depending on the dynamics of a particular project. Most lenders will require that sponsor capital is injected at the outset, and before the banks start funding the project company. They may, however, relax this position if they are satisfied as to the credit standing of the sponsors or have received security (such as a bank guarantee or letter of credit) to secure the sponsor’s capital commitment. Shareholder funds are usually injected by way of a subscription for shares of the project company, although there is usually no objection to shareholder loans so long as these are subordinated to the lenders’ loans and are non-interest bearing (or at least the requirement to pay interest is suspended until dividends are permitted to be paid (see below))
• The dividend/distribution policy of the sponsors. This will frequently be a source of much debate with the project lenders. On the one hand, most sponsors will be keen to extract profits at an early stage. The project lenders, however, will not be keen to see the sponsors taking out profits until the project has established and proved itself and the project lenders have been repaid at least some of their loans. It would be unusual for the project lenders to permit the payment of dividends (or the payment of interest on subordinated loans) prior to the date of the first repayment of the project loan and then only if the key project cover ratios will be satisfied after the payment of the dividends (see section 8.5 for an explanation of key cover ratios)
• Management of the project vehicle. Who will undertake this and how? Will the project vehicle have its own employees and management or will these be supplied by one or more of the sponsors? If one or more of the sponsors is to supply management and/or technical assistance to the project company, then the lenders will expect to see this arrangement formalised in an agreement between the sponsor in question and the project company
• Sale of shares and pre-emption rights. This will be of concern to sponsors and lenders alike. In particular, the lenders will want the comfort of knowing that the sponsor group that has persuaded them to lend to the project company in the first place will continue to be in place until the loans have been repaid in full.

Project implementation and management

The implementation of a project financing is a complicated, time-consuming and difficult operation. For most projects it is a case of years rather than months from inception of the project to reach financial close. It is not unheard of for some complex (and, perhaps, politically sensitive) projects to have a gestation period in excess of five years. The chart in Fig. 3 is an illustration of the more important milestones for a typical project and how long one might expect the process to take. However, each project will have a unique timetable, driven largely by the particular dynamics and circumstances of the project.

With so many parties involved having conflicting interests, the issue of effective project management assumes great significance in most project financings. It does not matter whether the overall responsibility is assumed by the sponsors (and their advisers) or by the lenders (and their advisers). What is crucial, however, is that one of the influential parties assumes overall control for managing the project from its inception to financial close. Without effective project management, a project can very easily go off the rails, with each of the parties singularly concentrating on issues and documents that are relevant to it. Because of the need to understand all aspects of the project with a view to assessing the overall risk profile, it is often the lenders (and their advisers) who are in the best position to manage effectively and steer a project to financial close.

Parties To A Project Financing

Parties and their roles

One of the complicating (and interesting) features of most projects is the considerable number of parties with differing interests that are brought together with the common aim of being involved to a greater or lesser extent with a successful project. It is one of the challenges of those involved with a project to ensure that all of these parties can work together efficiently and successfully and cooperate in achieving the project’s overall targets. It is inevitably the case that, although all of the parties will share the same overall aim in ensuring that the project is successful, their individual interests will vary considerably and, in many cases, will conflict. With many projects, there will be an international aspect which will involve different project parties located in different jurisdictions and there will often be tensions between laws and practices differing from one country to another.

A common feature in many project structures is that different parties will have particular roles to play. This is especially so with many multi-sponsor projects where, for example, one sponsor may also be the turnkey contractor, whereas another sponsor may be the operator and yet another sponsor may be a supplier of key raw materials to the project or an offtaker of product from the project. Frequently it is the case (and sometimes a requirement of local laws) that one of the sponsors is a local company. Even in those countries where the involvement of a local company is not a requirement, this can have many advantages particularly where the foreign sponsors have limited experience of business practices or laws in the host country. Further, the involvement of a local company offers a degree of comfort, for the foreign sponsors and lenders alike, that the project as a whole will not be unfairly treated or discriminated against.

No two projects will have the same cast of “players” but the following is a reasonably comprehensive list of the different parties likely to be involved in a project finance transaction.

Project company/borrower

The project company will usually be a company, partnership, limited partnership, joint venture or a combination of them. As noted in section 1.5, this will be influenced to a certain extent by the legal and regulatory framework of the host government. For example, in some jurisdictions it will be a legal requirement that the holder of a licence or concession be a company incorporated in that particular country. In other there may be strict requirements in particular industries as to foreign ownership of share capital or assets, particularly in strategically important industries.

The project company will in most cases be the vehicle that is raising the project finance and, therefore, will be the borrower. It will also usually be the company that is granted the concession or licence (in a concession-based financing) and who enters into the project documents. As has been seen in section 1, the project company is frequently a special purpose vehicle set up solely for the purposes of participating in a particular project. If the project vehicle is a joint venture then it is likely that there will be multiple borrowers. This can complicate the financing arrangements unless (as is likely to be the preference of the lenders) the joint venturers agree to be jointly and severally liable for the project’s debts. Where, however, the borrower is a special purpose vehicle, then the lenders would expect a newly incorporated company in the relevant jurisdiction and would seek to impose strict covenants on the ability of the borrower to undertake any non-project activities. The purpose of this is to ensure that the lenders are not exposed to any additional risks unrelated to the project itself. An example of the type and scope of such covenants is set out below.

Single Purpose Vehicle Covenants

The Project Company shall not:

• engage in any business or activity, apart from the ownership, management and operation of the Project and activities ancillary thereto as permitted by this Agreement and the Security Documents or
• save as contemplated in the Security Documents, create, incur or permit to subsist any Security Interest over all or any of its present or future assets, other than any Security Interest arising by operation of law and discharged within 30 days or
• make any advances, grant any credit (save in the routine course of its day-to-day business) or give any guarantee or indemnity to, or for the benefit of, any person or otherwise voluntarily assume any liability, whether actual or contingent, in respect of any obligation of any other person, except pursuant to the Security Documents or
• issue any further shares (other than to an existing direct or indirect shareholder) or alter any rights attaching to its issued share capital in existence at the date hereof or• save in accordance with the terms of this Agreement and the Security Documents, sell, lease, transfer or otherwise dispose of, by one or more transactions or series of transactions (whether related or not), the whole or any part of its assets or
• incur any indebtedness other than the Project Loan, unless such indebtedness is subordinated in terms of both payment and security to the satisfaction of the Project Lenders to all amounts due under this Agreement or• save in accordance with the terms of this Agreement and the Security Documents, acquire any asset or make any investment or
• amend its constitutional documents or
• change its financial year.

Sponsors/shareholders

The project sponsors are those companies, agencies or individuals who promote a project, and bring together the various parties and obtain the necessary permits and consents necessary to get the project under way. As has been noted in section 1, often they (or one of their associated companies) are involved in some particular aspect of the project. This might be the construction, operation and maintenance, purchase of the services output from the project or ownership of land related to the project. They are invariably investors in the equity of the project company and may be debt providers or guarantors of specific aspects of the project company’s performance. Some of the different ways in which the sponsors/shareholders invest in a project are explained in section 1.5.

The support provided by project sponsors varies from project to project and includes the giving of comfort letters, cash injection commitments, both pre- and post-completion, as well as the provision of completion support through guarantees and the like. Support is also likely to extend to providing management and technical assistance to the project company. The different types of sponsor support for a project are covered in more detail in section 6. [INSET IMAGE]

Third-party equity

These are investors in a project who invest alongside the sponsors. Unlike the sponsors, however, these investors are looking at the project purely in terms of a return on their investments for the benefit of their own shareholders. Apart from providing their equity, the investors generally will not participate in the project in the sense of providing services to the project or being involved in the construction or operating activities.

Third-party investors typically will be looking to invest in a project on a much longer time frame than, say, a typical contractor sponsor, who will in most cases want to sell out once the construction has been completed.

Many third-party investors are development or equity funds set up for the purposes of investing in a wide range of projects and they are starting to become a valuable source of capital for projects. Typically, they will require some involvement at board level to monitor their investment.

Banks

The sheer scale of many projects dictates that they cannot be financed by a single lender and, therefore, syndicates of lenders are formed in a great many of the cases for the purpose of financing projects. In a project with an international dimension, the group of lenders may come from a wide variety of countries, perhaps following their customers who are involved in some way in the project. It will almost certainly be the case that there will be banks from the host country participating in the financing. This is as much for the benefit of the foreign lenders as from a desire to be involved on the part of the local lenders. As with the involvement of local sponsors, the foreign lenders will usually take some comfort from the involvement of local lenders.

As is usually the case in large syndicated loans, the project loan will be arranged by a smaller group of arranging banks (which may also underwrite all or a portion of the loan). Often the arranging banks are the original signatories to the loan agreement with the syndication of the loan taking place at a later date. In such cases the arranging banks implicitly take the risk that they will be able to sell down the loan at a later stage.

However, participating in project financings is a very specialised area of international finance and the actual participants tend to be restricted to those banks that have the capability of assessing and measuring project risks. This is not to say that banks not having these skills do not participate in project financings, but for these banks the risks are greater as they must also rely on the judgement of the more experienced banks.

The complexity of most project financings necessitates that the arrangers are large banks with experience in this market, often having dedicated departments of specialists. For the smaller banks with an appetite for this kind of lending, however, there is usually no shortage of opportunities to participate in loans arranged by the larger banks.

Facility agent

As with most syndicated loans, one of the lenders will be appointed facility agent for the purposes of administering the loan on behalf of the syndicate. This role tends to assume an even greater significance in project financings as inevitably there are more administration matters that need undertaking. Usually, however, the role of the facility agent will be limited to administrative and mechanical matters as the facility agent will not want to assume legal liabilities towards the lenders in connection with the project. The documentation will, therefore, establish that the facility agent will act in accordance with the instructions of the appropriate majority (usually 66 2/3 per cent) of the syndicate who will vote and approve the various decisions that need to be taken throughout the life of a project. The documentation, however, may reserve for the facility agent some relatively minor discretions in order to avoid delays for routine consents and approvals.

Technical bank

In many project financings a distinction is drawn between the facility agent (who deals with the more routine day-to-day tasks under the loan agreement) and a bank appointed as technical bank, which will deal with the more technical aspects of the project loan. In such cases it would be the technical bank that would be responsible for preparing (or perhaps reviewing) the banking cases and calculating the cover ratios (see section 8.5 for a more detailed explanation of cover ratios). The technical bank would also be responsible for monitoring the progress of the project generally on behalf of the lenders and liaising with the external independent engineers or technical advisers representing the lenders. It will almost always be the case that the technical bank will be selected for its special ability to understand and evaluate the technical aspects of the project on behalf of the syndicate.

As with the facility agent, the technical bank will be concerned to ensure that it is adequately protected in the documentation and will be seeking to minimise any individual responsibility to the syndicate for its role as technical bank.

Insurance bank/account bank

In some of the larger project financings additional roles are often created for individual lenders, sometimes for no other reason than to give each of the arranging banks a meaningful individual role in the project financing. Two of these additional roles are as insurance bank and as account bank.

The insurance bank, as the title suggests, will be the lender that will undertake the negotiations in connection with the project insurances on behalf of the lenders. It will liaise with an insurance adviser representing the lenders and its job will be to ensure that the project insurances are completed and documented in a satisfactory manner and that the lenders’ interests are observed.

The account bank will be the lender through which all the project cash flows flow. There will usually be a disbursement account to monitor disbursements to the borrower and a proceeds account into which all project receipts will be paid. Frequently, however, there will be a number of other project accounts to deal with specific categories of project receipts (e.g. insurances, liquidated damages, shareholder payments, maintenance reserves, debt service reserves). A more detailed description of the project accounts and their operation is set out in section 8.2.

Multilateral and export credit agencies

Many projects are co-financed by the World Bank or its private sector lending arm, the International Finance Corporation (IFC), or by regional development agencies, for instance the European Bank for Reconstruction and Development (EBRD), the African Development Bank or the Asian Development Bank.

These multilateral agencies are able to enhance the bankability of a project by providing international commercial banks with a degree of protection against a variety of political risks. Such risks include the failure of host governments to make agreed payments or to provide foreign exchange and failure of the host government to grant necessary regulatory approvals or to ensure the performance of certain participants in a project.

Export credit agencies also play a very important role in the financing of infrastructure and other projects in emerging markets. As their name suggests, the role of the agencies is to assist exporters by providing subsidised finance either to the exporter direct or to importers (through buyer credits). Details of the various multilateral agencies and ECAs and a description of the type of financing support they each provide in relation to projects are set out in section 9.

Construction company

In an infrastructure project the contractor will, during the construction period at least, be one of the key project parties. Commonly, it will be employed directly by the project company to design, procure, construct and commission the project facility assuming full responsibility for the on-time completion of the project facilities usually referred to as the “turnkey” model.

The risks associated with the construction phase are discussed in more detail in section 3.4. The contractor will usually be a company well known in its field and with a track record for constructing similar facilities, ideally in the same part of the world. In some large infrastructure projects a consortium of contractors is used. In other cases an international contractor will join forces with a local contractor. In each of these cases one of the issues that will be of concern to both the project company and the lenders is whether the contractors in the joint venture will assume joint and several liability or only several liability under the construction contract. This may be dictated by the legal structure of the joint venture itself (e.g. whether it is an unincorporated association or a true partnership, see section 1.5 for a discussion of the key differences). Lenders, for obvious reasons, will usually prefer joint and several liability.

Although most projects are structured on the basis that there will be one turnkey contractor, some projects are structured on the basis that a number of companies are employed by the project company to carry out various aspects of the design, construction and procurement process which are carried out under the overall project management of either the project company or a project manager. This is not a structure favoured by lenders as it can lead to gaps in responsibilities for design and construction. Lenders will also usually prefer that the project company divests itself of responsibility for project management and that this is assumed by a creditworthy entity against whom recourse may be had if necessary. This is discussed further in section 5.3.

Operator

In most infrastructure projects, where the project vehicle itself is not operating (or maintaining) the project facility, a separate company will be appointed as operator once the project facility has achieved completion. This company will be responsible for ensuring that the day-to-day operation and maintenance of the project is undertaken in accordance with pre-agreed parameters and guidelines. It will usually be a company with experience in facilities management (depending upon the particular project) and may be a company based in the host country. Sometimes one of the sponsors will be the operator as this will often be the principal reason why that sponsor was prepared to invest in the project.

As with the contractor, the lenders will be concerned as to the selection of the operator. They will want to ensure that the operator not only has a strong balance sheet but also has a track record of operating similar types of projects successfully.

The contractor and operator are not usually the same company as very different skills are involved. However, both play a key role in ensuring the success of a project.

Experts

These are the expert consultancies and professional firms appointed by the lenders to advise them on certain technical aspects of the project. (The sponsors will frequently also have their own consultants/professionals to advise them.) The areas where lenders typically seek external specialist advice are on the technical/engineering aspects of projects as well as insurances and environmental matters. Lenders will also frequently turn to advisers to assist them in assessing market/demand risk in connection with the project.

Each of these consultancies/professional firms will be chosen for its expertise in the particular area and will be retained to provide an initial assessment prior to financial close and, thereafter, on a periodic basis. An important point to note is that these consultancies/professional firms are appointed by (and therefore answerable to) the lenders and not the borrower or the sponsors. However, the cost of these consultants/professional firms will be a cost for the project company to assume and this can be a cause of friction. It is usual, therefore, for a fairly detailed work scope to be agreed in advance between the lenders, the expert and the sponsors.

Host government

As the name suggests this is the government in whose country the project is being undertaken. The role of the host government in any particular project will vary from project to project and in some developing countries the host government may be required to enter into a government support agreement (see section 6.7). At a minimum, the host government is likely to be involved in the issuance of consents and permits both at the outset of the project and on a periodic basis throughout the duration of the project. In other cases, the host government (or an agency of the host government) may actually be the purchaser or offtaker of products produced by the project and in some cases a shareholder in the project company (although not usually directly but through government agencies or government controlled companies). It is usually the case that the host government will be expected to play a greater role in project financing (whether in providing support, services or otherwise) in the lesser developed and emerging countries.

Whatever the actual level of involvement the host government of a particular country plays in project financings, its general attitude and approach towards foreign financed projects will be crucial in attracting foreign investment. If there has been any history of less than even-handed treatment of foreign investors or generally of changing the rules, this may act as a serious block on the ability to finance projects in that country on limited recourse terms.

Suppliers

These are the companies that are supplying essential goods and/or services in connection with a particular project. In a power project, for example, the fuel supplier for the project will be one of the key parties. In other projects, a particular supplier may be supplying equipment and/or services required during either the construction or the operating phase of the project. Both the contractor and the operator would also fall under this category. Many of the comments made with respect to the contractor and the operator will also apply to the suppliers. However, it is not always the case that the suppliers (and for that matter the purchasers) are as closely tied into a project structure as, say, the contractor and operator. The lenders may not therefore be in a position to dictate security terms to them to the same extent.

Where there is no long-term supplier of essential goods and/or services to a project, both the lenders and the project company are necessarily taking the risk that those supplies will be available to the project in sufficient amounts and quality, and at reasonable prices.

Purchasers

In many projects where the project’s output is not being sold to the general public, the project company will contract in advance with an identified purchaser to purchase the project’s output on a long-term basis. For example, in a gas project there may be a long-term gas offtake contract with a gas purchaser. Likewise in a power project the purchaser/offtaker may be the national energy authority that has agreed to purchase the power from the plant. However, it is not always the case that there is an agreed offtaker. In some projects (such as oil projects) there will be no pre-agreed long-term offtake contract; rather the products will be sold on the open market and to this extent the banks will take the market risk.

In some projects essential supplies to the project (such as fuel) and the project’s output (e.g. electricity) are purchased by the project company or, as the case may be, sold on “take-or-pay” terms. In other words the purchaser is required to pay for what it has agreed to purchase whether or not it actually takes delivery. This type of contract is discussed in more detail in section 3.4.

Insurers

Insurers play a crucial role in most projects. If there is a major catastrophe or casualty affecting the project then both the sponsors and the lenders will be looking to the insurers to cover them against loss. In a great many cases, if there was no insurance cover on a total loss of a facility then the sponsors and lenders would lose everything. Lenders in particular, therefore, pay close attention not only to the cover provided but also to who is providing that cover. Most lenders will want to see cover provided by large international insurance companies and will be reluctant to accept local insurance companies from emerging market countries.

In some industries (e.g. the oil industry) some of the very large companies have set up their own offshore captive insurance companies, either for their own account or on a syndicate basis with other large companies. This is, in effect, a form of self-insurance and lenders will want to scrutinise such arrangements carefully to ensure that they are not exposed to any hidden risks.

In other cases, insurance cover for particular risks either may not be available or may be available only at prohibitive premiums or from insurers of insufficient substance or repute. In such cases the lenders will want to see that alternative arrangements are made to protect their interests in the event of a major catastrophe or casualty. These and other insurance issues are examined in more detail in section 7.

Other parties

There will be other parties such as financial advisers, rating agencies, local/regional authorities, accountants, lawyers and other professionals that have a role to play in many projects to add to the complexity. Add to this the fact that very often each of these parties will have its own separate legal and tax advisers and it can be seen that the task of legal coordination of these projects can (and frequently is) a difficult, time-consuming and expensive process. This makes effective project management an essential and key part of the success of the implementation of a project (see section 1.7).

Summary of key lenders’ concerns

Before agreeing to lend to a particular project, the lenders will pay specific attention to each of the parties that will have an involvement (however small) in the project, whether at inception, during the construction phase or during the operating phase. It is not an exaggeration to say that, in the case of many project financings, the robustness of the overall project structure is only as strong as its weakest link. The following are some of the key issues that the lenders will focus on:

• The creditworthiness of the parties and, in particular, whether they have sufficient financial resources to meet their obligations under the relevant project documents. If the lenders are not so satisfied, then they are likely to call for guarantees or letters of credit from parent companies or other banks and financial institutions to support these obligations
• Equally important is the ability of the parties to deliver and perform according to the specifications of the project documents. Do the parties have sufficient technical and management resources? Have they experience of similar projects in similar circumstances? Have they undertaken similar arrangements in the relevant country? These are all issues that the lenders will ask themselves before committing to a particular project
• What, if any, relationship does a particular project party have to the project company? As has been noted in this section, it is frequently the case that one of the sponsors will be the contractor, the operator or a major supplier to, or purchaser of output from, the project. In most cases this is likely to be viewed by the lenders favourably; but in some cases the lenders may be concerned to ensure that a proper arm’s-length relationship prevails
• Independence of the project parties, i.e. are they likely to be influenced in any way by local political considerations in such a way as might be detrimental to the lenders? Clearly, foreign parties are less likely to be susceptible to local political or other pressures than local companies and this can sometimes be a concern for lenders
• Continuity, i.e. will a particular project party continue to be involved in the particular project for the duration of the lenders’ involvement? Lenders will usually seek to impose restrictions on the transfer of obligations under project documents by key project parties and where this is not possible then the occurrence of such a transfer might constitute an event of default
• In the case of parties providing technical advice (such as engineers, insurance advisers and lawyers) to the lenders, do they have sufficient professional indemnity insurance cover in place to cover negligent advice? Negligent advice could turn out to be disastrous for the lenders and it would be unfortunate if in those circumstances they had no recourse to the source of such negligent advice
• The lenders will be concerned to ensure that each party that contracts with the project company is duly authorised to enter into contracts with the project company and that its obligations under these contracts constitute its legal, valid, binding and enforceable obligations. To ensure this, the lenders will require legal opinions from lawyers in the home jurisdiction of each such project party. Special attention will often be paid to ensuring the validity and enforceability of the obligations of governments and state authorities or institutions as all too frequently it seems questions arise over their role or participation in projects that are being privately financed

It will be apparent that in many of these instances the concerns of the lenders and the project company/sponsors will be the same, each wants to minimise the risk of external influences or events acting to the detriment of the project.

Project Financing Documentation

Role of documentation

The essence of project financing is the apportionment of project and other risks amongst the various parties having an interest in that project. The way in which this risk allocation is implemented is, essentially, through the complex matrix of contractual relations between the various project parties as enshrined in the documentation entered into between them. There is no general body of law in England (or elsewhere) that dictates how projects must be structured or how the risks should be shared amongst the project parties. Rather, each project must fit within the legal and regulatory framework in the various jurisdictions in which it is being undertaken or implemented. Accordingly, the contracts between the various project parties assume a huge significance and it is these documents that are the instruments by which many of the project risks are shared amongst the project parties. As will be apparent, there is no such thing as a standard set of project documents. Each project will have its own set of documents specially crafted for that particular project. Set out below is a brief description of some of the key documents found in many project financing structures. These documents can conveniently be grouped as follows:

• Shareholder/sponsor arrangements
• Loan and security documents
• Project documents.

Shareholder/sponsor documentation

Pre-Development Agreements

These are agreements entered into by two or more companies that have agreed to undertake a feasibility study in relation to a proposed project. As the arrangements between the parties will not usually be sufficiently well developed to warrant a formal shareholders’ agreement, this document can conveniently deal with such matters as initial decision-making and allocation of tasks in relation to investigating a particular project or proposal. Typically, the agreement would be for a limited duration and would be quite specific about the scope of the proposed arrangements and the terms upon which a party could withdraw from the arrangements. It would also deal with appointment of advisers and general cost sharing. One might also expect to see provisions relating to confidentiality and restrictions on competing. Similar agreements may also be entered into where parties join together to bid for a particular contract or concession and do not want to incur the cost or expense of a formal joint venture agreement or shareholders’ agreement unless they are successful in their bid.

Shareholders’ Agreement/Joint Venture Agreement

In those projects where the project is being undertaken using a special purpose vehicle owned by two or more shareholders, those shareholders will usually regulate the relationship between them by entering into a shareholders’ agreement. On the other hand, where a joint venture structure is used, a joint venture agreement will usually be entered into. A shareholders’ agreement in relation to a project will not differ greatly from a shareholders’ agreement relating to the ownership of any other company and will need to deal with items such as:

• Injection of share capital; how much, when and in what form
• Funding of the project company
• Voting requirements for particular matters
• Resolution of disputes
• Dividends policy
• Management of special purpose vehicle
• Disposal of shares and pre-emption rights.

A joint venture agreement will contain many of the same provisions although will not need to deal with those matters concerning the setting up and management of a special purpose vehicle. It will, however, have to deal with management of the project and voting in connection with the project generally

From the point of view of the project lenders, they are likely to be concerned with a number of issues with regard to the sponsors/shareholders. Perhaps the key issues for them will be:

• The identity of the sponsors/shareholders and their experience and creditworthiness. Where shareholders/sponsors nominate a subsidiary to undertake any responsibilities or obligations with regard to a particular project, then the project lenders may well demand guarantees from the parent companies to support their subsidiaries until the project debt is repaid
• If the shareholders/sponsors are committing management resources and/or expertise for the special purpose vehicle and/or the project, then the lenders will want to see these obligations spelt out in very clear terms and to know which shareholder/sponsor will be providing which services and on what terms. Quite often, these arrangements are set out in a separate management/supervision agreement
• If the shareholders/sponsors agree to put up further equity at a later date, then the terms and conditions upon which this equity is put up will need to be spelt out very clearly (in many, if not most, cases the lenders are likely to require that the shareholders put up their funds first or at least proportionate to loan drawdowns). From the perspective of the lenders, rather than take an assignment by way of security of such a commitment owed by the sponsors/shareholders to the project company, the lenders are likely to require direct equity undertakings from the sponsors/shareholders for a number of reasons. Amongst these is the fact that an assignee cannot claim for a loss in excess of that of the assignor and it might very well be the case that the lenders’ actual loss is considerably greater than that of the project company should the sponsors/shareholders default. It may also be the case that set-offs/counterclaims could exist between the project company and the sponsors/shareholders, which would have the effect of reducing the sponsors’/shareholders’ obligations. A further weakness is that an obligation to subscribe for equity in the project company will not survive the project company’s liquidation thus depriving the lenders of this source of funds when they might most need it. Further, any claims by the lenders for breach of such equity commitments would be a damages-based claim which suffers from the weaknesses, from a lender’s perspective, that the normal common law rules as to causation, remoteness and mitigation of damages will apply (see section 1.3 for a more detailed explanation of this issue). For the lenders it would be better for an equity commitment to be constructed as a financial guarantee or indemnity albeit limited to the amount of the equity commitment although this may well be resisted by the sponsors/shareholders.

If, as is often the case, the project company is a party to the shareholders’ agreement and is the beneficiary of any rights and/or benefits under this agreement, then the project lenders are likely to want an assignment by way of security of the benefit of this agreement as part of their overall security package.

Sponsors Shareholders Support Agreement

In some project financings, the sponsors/shareholders will enter into a support agreement with the project company and the lenders. This agreement is likely to contain a number of commitments that the lenders require of the sponsors/shareholders with respect to the project and the project company (some of which might otherwise be found in a sponsors’/shareholders’ agreement), including:

• A requirement to provide management and technical assistance (including, where necessary, secondment of key employees)
• A requirement to provide funding, whether through subscription for equity or by the provision of loans (it is likely that the lenders will require any loans to be unsecured and subordinated to the project loans)
• Restrictions on the ability of the sponsors/shareholders to dispose of their shares in the project company
• Any completion guarantees or cost overrun guarantees to be given by the sponsors/shareholders (or any of them)
• Any security requirements from the sponsors/shareholders supporting their commitments to provide equity at a later stage

Loan and security documentation

Project Loan Agreement

In most projects this will be a syndicated loan agreement entered into between the borrower, the project lenders and the facility agent. It will regulate the terms and conditions upon which the project loans may be drawn down and what items of project expenditure the loans may be used for. The agreement will contain the usual provisions relating to representations, covenants and events of default found in other syndicated loan agreements but expanded to cover the project, project documents and related matters. The provisions relating to the calculation and payment of interest will be similar for standard Euro-currency, loans except that in most projects interest will be capitalised during the construction period or until project revenues come on stream. [IMAGE] AgreementRepayment terms will vary from project to project and will often be tied to the receipt of project cash flows and/or the dedication of a minimum percentage of the project’s cash flow towards debt service. The agreement will normally provide for all project cash flows to flow through one of a number of project accounts maintained by the agent (or a security trustee or account bank) and charged to the project lenders. There will be detailed mechanics relating to the calculation of project cover ratios and the preparation of banking cases and forecasting information with respect to the project (see section 8.5 for a more detailed discussion of cover ratios). There will also be provision for the appointment of consultants, advisers and technical experts by the project lenders. The balance of the agreement will contain boilerplate provisions customarily found in Euro-currency loan documentation adapted, as appropriate, for a project financing.

Security Documents

The form of these will vary from jurisdiction to jurisdiction and will depend on the nature and type of assets that are the subject of the security. A more detailed description of the type of assets and security found in project financings is set out in section 6. In common law based jurisdictions the taking of security in relation to project financing is usually through a fixed and floating charge covering all of the property and assets of the project company. In civil law based and other legal systems, however, the position is usually more complex, with different documents being required for different categories of assets.

In those jurisdictions that recognise trusts, it is usually convenient to appoint a trustee (often one of the banks) to hold the security on trust for the lenders as this not only insulates the security from the insolvency of the institution holding the security but also facilitates the trading of rights and obligations by the banks without the risk of disturbing the security.

Where a security trustee is appointed by the project lenders, this is usually under a separate security trust deed which sets out the terms of appointment, rights, duties and obligations of the security trustee, as well as provides for the usual indemnity and exculpatory provisions for the benefit of the trustee. Also, the security trust deed may deal with the order of application of payments amongst the various groups of lenders, although this is frequently dealt with in a separate intercreditor agreement. The applicable governing law for a security document will depend to a great extent on the location of the asset over which security is being taken. The basic rules for determining the correct governing law for security assets is set out in section 6.9.

Project documents

Concession Agreements/Licences

In many projects, particularly Build-Operate-Transfer (“BOT”) projects, the concession agreement will be the key project document as it is the document that will vest in the project company the right to explore, exploit, develop or operate, as appropriate, the concession or other relevant rights to the project. At the other end of the spectrum, all that may be needed for a project company to be vested with the necessary legal rights to exploit is a licence. Thus, for example, in an oil and gas financing in the UK continental shelf, the project vehicle will be a beneficiary of (or the beneficiary of a share of) a licence issued by the Department of Energy and Climate Change which entitles it to explore for and exploit hydrocarbons on the terms set out in the licence (and certain model clauses applicable to the licence). On the other hand, in a BOT project, it will invariably be the case that the project vehicle (or its sponsors) will be granted a concession by the host government (or one of its agencies) with respect to the project. The concession agreement, often comprising a BOT obligation, but sometimes a build-own-operate obligation, is popular particularly in countries where political or budgetary constraints prevent governments from developing essential and increasingly expensive infrastructure in the public sector. A concession can offer the host government certain advantages, including:

• Minimising the impact of the project on its capital budget
• Introducing increased efficiency into the project
• Encouraging foreign investment and the introduction of new technology.

The BOT structure ends with the transfer back of the project to the relevant state authority at some future date. This may result in the state receiving a useful operational project, although sometimes the transfer is not provided to occur within the economic life of the project. The terms which may commonly be found in concession agreements are covered in some detail in section 4, but key features are:

• The grant of a concession for a designated period of time (from the lenders’ perspective this will need to exceed the term of the project loan by a comfortable margin)
• The duties and obligations imposed on the project company with respect to the project and the concession
• Certain undertakings given by the concession grantor, e.g. as to non-competition, provision of utilities and other services provisions concerning certain changes in law
• Where appropriate, payment of concession fees
• Default and forfeiture terms
• Assignments and transfers (the project lenders will want to be certain that they can have the benefit of the concession assigned to them by way of security)
• Termination terms, including handover provisions (e.g. education and training where applicable).

In addition to some of the points noted above, the project lenders will be concerned to ensure that the concession grantor cannot unilaterally vary or terminate the terms of the concession, that the concession is transferable to any purchaser of the project (or project vehicle) and that the concession grantor should also assume at least certain risks associated with change of law and/or force majeure circumstances. Depending on the circumstances of a particular project, the project lenders may want to enter into a direct agreement with the concession grantor to address a number of the above and other concerns (see section 6.6).

Construction Contracts

In an infrastructure project where the project lenders are taking all or any part of the construction/completion risk, the construction contract will be one of the key project documents. There are a number of standard form construction contracts in use but it is unlikely any of them will be suitable for a project-financed contract without significant amendment. The closest to a suitable international standard contract is probably the “Orange Book” published by FIDIC.

The most common arrangement is a turnkey contract, in which a single “general” contractor assumes all risk of on-time completion of a project which meets guaranteed performance standards. In a turnkey contract, the owner specifies overall performance and reliability standards for the plant, and the turnkey contractor assumes full responsibility for design, construction, supply, installation, testing and commissioning of the plant so as to enable it to meet those specified requirements. Subject to important limitations which the contract will contain, the turnkey contractor essentially provides an overall guarantee of the performance of all components and sub-contractors.

As an alternative arrangement to a turnkey contract, sponsors may consider that they have the necessary experience to manage the design and construction of the project facility and may wish to undertake this themselves, or to leave certain responsibilities for it with the project company. Sponsors may perceive that they will be able to achieve an overall cost or time saving if they perform a role in relation to some or all of the design or construction of the facility. If construction management responsibilities are undertaken by the project company or sponsors, lenders will need to be satisfied with their technical capacity and resources. They may wish to have additional sponsor support to ensure adequate cover against the absence of a single contractor that has overall responsibility and the likely consequences of mismanagement during design and construction.

Even less popular with lenders is a project management structure whereby a project management agreement is entered into with one project managing company which will then arrange for individual contractors to enter into contracts with the project company. In this case each of these individual contractors would carry out different parts of the project. One of the reasons lenders have a very strong preference for turnkey contracts is that they reduce the risk of claims arising between the different contractors and of unallocated responsibilities relating to the project. If a turnkey contract is not utilised, then the project lenders will need to spend considerably more time analysing the construction contracts and the risks arising from the construction arrangements.

The key provisions of a typical construction contract, and its significance for the arrangement of project finance, can be summarised as follows:

Price and payment terms

Contractors usually prefer to be paid by stage payments. Contracts for the provision of industrial plant commonly provide for a substantial advance payment upon or soon after contract signing and thereafter for agreed instalments of the price to be paid against achievement of specific progress “milestones”.

Contractors will tend to have a preference for minimising the transfer of risk under the contract, so that its terms provide for the price to be adjusted if unforeseen circumstances or events render the assumptions on which the original price was quoted inapplicable. Not surprisingly, project lenders, on the other hand, prefer as much certainty as possible about the price. They will seek to maximise the transfer of risks to the contractor and to maximise its liability for breaches of contract, at least sufficient to preserve the project company’s projected cash flow.

Lenders are likely to look at any provision for variation of the price very carefully as this may increase the risk for the project lenders by making it uneconomic for the project lenders to complete the project should they have to take it over following a default by the project company. Lenders will, for example, seek to require that their consent be obtained before the project company exercises its rights under the construction contract to instruct variations in the works being produced, or to suspend the work

The sponsors’ interests will not be exactly the same as those of the lenders. Sponsors will seek not only certainty of price, but also a competitive price. As regards the contractor’s liability for breaches of contract, sponsors will seek the optimum balance against price.

Completion

Construction contracts often permit the completion date to be postponed if the contractor is unable to comply with the construction contract date for reasons beyond its control. Project lenders prefer as much certainty as possible, but will usually accept postponement in limited specified circumstances. However, any provisions for postponement will need to be mirrored in the other project agreements, so that failure to achieve