Security Arrangements and Legal Structures in International Project Finance

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Security Arrangements and Legal Structures in
International Project Finance
ACADEMY OF ECONOMIC STUDIES FACULTY OF
INTERNATIONAL BUSINESS AND ECONOMICS
Lecture 4

• Lect. Cristian PAUN

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International Project Finance Risks

• In a project finance, lenders require to the
  sponsors to provide assurance that
• The project will completed even if construction
  costs will exceed those originally projected
• After its completion, the project will generate
  enough cash to meet all its debt service
  obligations
• If or any reason (including force majeure) the
  projects operations are interrupted, suspended
  or terminated, the project will continue to
  service (until fully repayment as scheduled) its
  debt obligations.
• This credit strength offered by assurances
  mentioned above is often supplemented by a set of
  security arrangements between the sponsors and
  other creditworthy parties of the project.

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Purpose of Security Arrangements

• Arranging sufficient credit support for the
  project is a necessary precondition for project
  debt financing
• The contractual security arrangements will ensure
  a lower risk for the project financing
• The security arrangements ensure provide a legal
  recourse of the creditor on different third
  parties involved in the project (the purchasers
  of the projects outputs, providers of raw
  materials)
• The nature and dimension of these security
  arrangements will depend on the type and the
  magnitude of the total project risk, the
  profitability of the project and the financial
  strength of the parties.
• The adequacy of such security arrangements
  depends on the creditworthiness of the parties so
  obligated.

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Security arrangements covering completion

• The security arrangements covering completion
  typically involve an obligation to bring the
  project to completion or else repay all project
  debt
• Lenders require that the sponsor or other
  creditworthy parties to provide an unconditional
  undertaking to furnish any funds needed to
  complete the project in accordance with the
  design specifications and place it into service
  by a specific date
• Completion of the project will occurs when
• The sponsor of the project have accepted the work
  performed under the construction contract and
  agreed to make the payments
• The project has sustained a certain specified
  level of operations over a specified period of
  time mentioned in the completion agreement.
• A completion undertaking requires that the
  sponsor stand by to provide whatever additional
  funds are needed to complete the project when
  additional costs occur.

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Project Description
Completion security arrangements
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Security arrangements covering debt service

• After the project completion, contracts for the
  purchase and sale of the projects outputs (goods
  or services) represents the principal security
  arrangements for the projects debt service.
• These security arrangements are intended to
  ensure that the project will receive revenues
  that are sufficient to cover operating costs
  (incl. projects debt service).
• Lenders typically require that creditworthy
  parties either directly guarantee the project
  debt or else provide assurances contractually
  that the debt will be fully serviced out of
  project revenues
• The factors that determine the most appropriate
  security arrangements include
• The type of facilities involved
• The nature of the purchase contracts
• The parties to the contract
• The projects inherent risks.

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Type of purchase and sale contracts
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Type of purchase and sale contracts (cont.)
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Security arrangements covering supply

• Raw materials supply agreements obligate the
  providers of the projects inputs to lend credit
  support to the project company
• A supply or pay contract forces the
  supplier to furnish the necessary raw materials
  for the project or else make payments to the
  project entity that are sufficient to pay the
  debt service.

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Additional Security Arrangements

• Depending on the structure and the complexity of
  the project, it may be necessary to provide
  supplemental credit support through additional
  security arrangements
• These arrangements will operate in the event the
  completion arrangements or the purchase and sale
  contracts fail to provide enough cash to cover
  debt service
• Additional Security Arrangements may include
• Financial Support Agreement
• Cash Deficiency Agreement
• Capital Subscription Agreement
• Escrow Fund
• Insurance.

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A. Financial Support Agreement

• Can take the form of a letter of credit or
  similar guarantees provided by the project
  sponsors to cover the obligations of the project
  company
• Such forms of credit support are frequently used
  in connection with commercial paper financings
  (bill of exchange).

B. Cash Deficiency Agreement

• A cash deficiency agreement is designed to cover
  any cash shortfalls that would affect the
  projects capacity to meet its debt service
• The obligor makes the cash payments sufficient to
  cover the cash deficiency.

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C. Capital Subscription Agreement

• Capital Subscription Agreement forces one ore
  more creditworthy parties to purchase for cash
  securities issued by the project company, in
  order to cover the cash shortfall.

D. Escrow Fund

• Lender may require to the project company to
  create an escrow fund that usually cover a period
  between 12 and 18 month debt service
• A specified trustee can draw money from the
  escrow fund when the cash flow from operation
  proves to be insufficient to cover the projects
  debt obligations.

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E. Insurance Policies

• Lenders typically require that insurance be taken
  to protect against certain risks of force
  majeure
• The project sponsors normally purchase commercial
  insurance to cover the cost of damage caused by
  natural disasters
• Country risk, political risk, transfer risk and
  sovereign risks can be insured to specific
  insurance companies (COFACE, MITI)
• They may also secure business interruption
  insurance to cover certain other risks (water
  level of the river in case of a hydropower plant).

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Conclusions

• Security Arrangements are designed to increase
  the credit strength of the project
• Security Arrangements increase the proportion of
  a projects construction and operation costs that
  can be funded with project borrowings
• Security Arrangements can be divided in two
  distinctive categories
• Those that ensure projects completion
• Those that ensure the debt service (purchase and
  sale agreements and additional agreements).
• The security arrangements depends on the
  complexity of the project, the characteristics
  and risk return preferences of the
  participants
• The security arrangements are undertakings that
  share the risk and financial returns between the
  participants.

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Legal Structures in International Project
Finance
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Optimal Legal structure for a Project

• The appropriate legal structure for a project
  company depends on a variety of business, legal,
  accounting tax and regulatory factors
• Optimal legal structure for the project entity is
  determined taking into consideration the
  following
• The number of participants and their objectives
• The projects capital cost and the expected
  return
• The existing debt instruments and the tax
  position of the participants on the host country
• The political jurisdiction on the country where
  the project will operate
• The requirements of regulatory bodies (promoters
  and sponsors).

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Legal structure for a project company

• The most used legal structures in case of a
  project company are
• Undivided Joint Interest
• Corporation
• Partnership
• Limited Liability Company.

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A. Undivided Joint Interest

• All property of the project is owned directly by
  the participants in common.
• Co-owners appoint an operator (usually a
  co-owner) to manage the project
• A steering committee composed by representative
  of all owners is required for major decisions
• Project costs and benefits are usually allocated
  in the same proportion as project ownership
• Each co-owner is responsible for providing its
  pro-rata share of the capital cost of the project
  from its own financial resources
• The co-owners are the taxable entities
• Can be used separate tax accounting methods by
  each co-owners
• Each participant reflects its proportionate share
  of project assets, revenues and operating
  expenses in its own financial statements.
• All tax consequences of project are transferred
  directly to the co-owners.
• No limitations on project deductions taken by
  participants
• Project income is taxed at co-owner level only.

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B. Corporation

• Project assets are owned by the corporation
• The project corporation operates the project
• Employees of the project corporation manage the
  project
• The equity owners (sponsors) are represented on
  the project corporations board of directors
• Costs and benefits are allocated by the contracts
  between the project corporation and other parties
  interested (the contracts cover completion,
  purchase and sale inputs and outputs,
  supplemental arrangements covering the projects
  debt obligations)
• Liability limited to equity invested except
  otherwise agreed
• Equity funds are submitted by the sponsors, the
  project company issues debt securities secured
  with the project company assets and sales
  contracts
• The financial vehicle is the project company or a
  special purpose corporate
• Project assets and liabilities are not reflected
  on equity holders balance sheet.

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B. Corporation (cont.)

• Project company is the taxable entity
• The tax accounting method is elected by the
  project company
• Project usually affects taxable income of equity
  holders only to the extend of dividends received
  from the project
• Project income is taxed at project corporation
  level.

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C. Partnership

• Project assets are owned by the partnership
• The project partnership operates the project
• One of the general partners is usually designated
  as a manager of partnership operations
• In the partnership agreement is specified which
  partner will operate the project and which
  partner will manage the project
• The partnership agreement specifies the rights
  and obligations of each partner.
• Project costs and benefits are typically
  allocated in proportion to project ownership
• Liability unlimited for general partners, limited
  liability for equity investors (limited
  partners)
• Sponsors provide equity in the form of partners
  capital contributions. The partnership issues
  debt securities secured with the partnership
  assets and contracts.

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C. Partnership

• Special Purpose Corporate subsidiary is the
  financing vehicle (SPV is owned 100 by the
  partnership)
• Project assets and liabilities are not reflected
  on equity holders balance sheet or on sponsors
  balance sheet
• If the sponsor contribution is material one (with
  equipments) in the financial statements of the
  sponsor there can be a footnote mentioning this
  contribution
• Taxable entity are the partners
• Election of tax accounting methods is made by the
  partners
• Project income is taxed at partner level only.

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C. Partnership - example
Sponsor X
Sponsor Y
Sponsor Z
100 ownership
100 ownership
100 ownership
X Subsidiary
Y Subsidiary
Z Subsidiary
20 ownership
40 ownership
40 ownership
XYZ Project Company (a partnership that owns and
operates the Project facilities)
100 ownership
XYZ Finance Corporation - SPV
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D. Limited Liability Company

• Project assets are owned by the project company
• The project company operates the project
• Employees of the project company manage the
  project
• The equity owners are represented on the project
  companys board of directors
• Allocations of costs and benefits is determined
  by the contracts between the project company and
  the other parties involved
• Equity owners have no direct liability for
  project obligations except as specifically
  defined in contractual undertakings
• Liability limited to equity invested except as
  otherwise agreed
• Equity funds are contributed by the sponsors
• The project company issues debt secured with the
  project assets and sales contracts
• The financing vehicle is the project company or a
  SP corporate subsidiary.

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D. Limited Liability Company

• Project assets and liabilities are not reflected
  on equity holders / sponsors balance sheet
• Shareholders in the project company is taxable
  entity
• The project company elect the tax accounting
  methods
• Project income is taxed at shareholder level
  only

Conclusions

• The choice of legal structure can have important
  tax implications on the project
• It can also affect the availability of funds to
  a project and the cost of raising project
  financing
• The choice of legal structure affects the risk
  return allocation between the parties involved in
  the project
• Financial and legal advisers will contribute to
  evaluate the best legal structure