The Project Finance Law Review: Project Finance Arrangements in General
I PROJECT FINANCE – INTRODUCTION
Project finance is a form of financing to fund a capital-intensive project based primarily on the ability of the project to be developed in a specified time frame within an agreed budget and generate revenues. Cashflow generated from the project upon its operationalisation is utilised towards servicing of the debt. It is an efficient way to finance large infrastructure projects that might otherwise be too expensive or speculative to be carried on a corporate balance sheet. Project finance structure revolves around the creation of a special purpose vehicle (SPV) that holds all the project's assets, including all of its contractual rights and obligations. For equity investors, the appeal of project finance is to maximise equity returns.
This form of financing is primarily based on the strength of the projected cash flows of the SPV. Relevantly, project finance in India (and a number of other developing nations) is not purely a non-recourse financing (which is the usual form of project financing in developed nations) but is usually a limited recourse funding, which basically means that the promoters or parent of the SPV provides an undertaking to the lenders till the commissioning of the project to, among other things, fund cost overruns (at times subject to caps), retain majority shareholding in the SPV, pledge its shareholding (either 51 per cent or more) to the lenders, and be responsible for creation of the debt service reserve.
Corporate financing on the other hand entails funding a group or existing corporate entity with a strong balance sheet and the main recourse is on the corporate entity.
Project finance transactions usually involve the following key stakeholders:
- the SPV, a newly incorporated company for developing the project;
- the sponsor or shareholder, the parent company of the SPV that is, inter alia, responsible for infusing equity into the proposed project and providing the required sponsor support to the lenders funding the project in most developing nations;
- the lenders, which extend long-term financial assistance to the SPV for the implementation of the project in an agreed debt-to-equity ratio, and enter into the financing and security documents;
- the engineering, procurement and construction (EPC) contractor, which is responsible for the construction of the project and an EPC contract is executed in this regard;
- the operations and management (O&M) contractor, which is appointed by the SPV for the operation and maintenance of the project after commissioning;
- the offtaker, which procures the project product and enters into an offtake agreement (the power purchase agreement (PPA) in power projects) to record the terms of the offtake (critical as this is the entity responsible for payment of revenues to the SPV);
- the landowner, from whom the land for the project is procured by a sale or lease deed executed by the SPV – the availability of encumbrance-free land being critical for large infrastructure projects;
- in power projects, the transmission entity, because contractual arrangements with the transmission licensee are required to get a right to extract power from the project; and
- the concessioning authority for infrastructure projects, such as road projects, ports, railways etc, which are granted on concession basis (under the public–private partnership (PPP) model).
II LOAN PROCESS
i Technical and financial evaluation of the project
As a first step, a project developer approaches the identified lenders with the details of the project either directly or through a syndicator. A project developer may avail project finance from domestic lenders or non-resident lenders. In the latter case, the financing would need to be structured in a manner that the terms of financing are in compliance with the extant Indian foreign exchange norms. Relevantly, the Indian government has, in recent times, significantly liberalised regulations governing foreign currency borrowing in India and lifted erstwhile restrictions on defined end uses, permitted borrowers etc.
Usually, project finance facilities are provided by a consortium of lenders, with one lender acting as the lead. Sometimes a bilateral facility is initially entered into, with the lead lender then selling on parts of the total commitment. The lender first evaluates the project from a technical and financial perspective and processes the loan application through its internal systems based on preliminary due diligence on the project. Based on this evaluation, usually the lender issues a term sheet or sanction letter setting out indicative terms and conditions (including relevant commercial assessments such as the pricing of the loan and security cover required) on which it would be willing to grant financing to the project, based on discussions with the borrower. Once this term sheet or sanction letter is agreed between the parties and issued, then the process of detailed due diligence on the project from a technical, financial and legal perspective commences. Simultaneously with this due diligence exercise, the preparation of the documentation for the grant of the financing is also commenced.
With the advent of the Insolvency and Bankruptcy Code, 2016 (followed with periodic amendments and landmark judicial pronouncements), bankruptcy remoteness of the project and the SPV is provided significant weightage by the lenders during the evaluation of the project.
Relevantly, in addition to factors such as the balance sheet of the parent company, valuation of the security being offered, bankability of the project documents etc., intangibles such as financial position of sector and policy initiatives by the government also assume importance while assessing viability of a project.
ii Legal due diligence of the project
Some of the main aspects that are discussed between the borrower and the lender during this phase are as follows.
BANKABILITY OF PROJECT DOCUMENTS
To obtain project financing, a borrower needs to ensure that the project documents that it executes for a project are bankable (as lenders would insist on this). Some of the project documents that are usually required as a condition precedent to funding by lenders are the EPC contract, concession agreements (in road projects) and PPA (for power projects). Some of the key project finance principles usually considered while drafting or reviewing project contracts are as follows:
- the EPC contract must be executed with the construction risk (for time delays and performance standards) adequately passed on by the SPV to the EPC contractor, with corresponding provisions for liquidated damages for delays and performance;
- there must be a guaranteed revenue stream from a creditworthy purchaser under the offtake agreement or PPA (in power sector projects) or the concession agreement for the PPP projects to support the economics of the project;
- the duration of the offtake arrangements or the PPA or the concession agreement for the PPP projects securing cash flows should match the tenure of project debt;
- there must be adequate performance security (to be assigned to the lenders) obtained from the EPC contractor to ensure performance of the EPC contract to mitigate construction risk;
- there must be warranties of appropriate substance and duration, and subsequent manufacturer coverage, to avoid the incurring of unbudgeted expenses by the project company (EPC contractor liability for design and installation defects);
- the O&M agreement must ensure adequate operation and management services for the project to ensure project performance at projected levels;
- there must be a collateral assignment of the main project contracts such as the EPC contract, PPA, the O&M contract, to ensure that the lenders are entitled to step into the shoes of the SPV on occurrence of an event of default; and
- the interface issues or risk allocation must be addressed in each of the project contracts so that the risk is allocated to the project stakeholder that is best equipped to manage the risk and to ensure that the entire risk does not sit with the SPV.
LAND DUE DILIGENCE
Land due diligence procedures are important to ascertain that the SPV has the legal right to the land where the project is to be developed, without any prior encumbrance. It is one of most critical aspects of the due diligence phase and project development, and an issue that needs to be confirmed as a condition precedent to funding by the lenders. Non-availability of land and related consents may lead to a delay in project implementation. The nature of the due diligence mainly depends on the type of the land involved, and mainly the land for projects is:
- government land;
- private land;
- forest land; or
- agricultural land.
The procurement process for different types of land is different and the title documents in favour of the SPV need to be verified. Additionally, the right to land could be ownership rights or leasehold rights (usually for a long duration and at least commensurate with the useful life of the plant). The main aim of conducting land due diligence is to ensure that the land has been acquired in accordance with the applicable local land acquisition laws, to ensure there are no outstanding historic claims on the land, and that all requisite approvals and consents for use of land for the project have been obtained by the SPV.
Another important aspect that needs to be verified is if the land title documents and related policies impose any restrictions or approval requirements for the creation of security in favour of the lenders over the project land. If prior permission is required in this regard, then it is a condition precedent to funding by lenders.
AVAILABILITY OF CONSENTS AND PERMITS FOR PROJECTS
Usually, lenders would require that all the required permits for a project to be developed and constructed are available prior to the first drawdown. Accordingly, at this stage the lenders check if all the required government permits are available with the borrower. Some of the usual permits required by a project are as follows:
- environment-related clearances (such as environmental clearance, forest clearances, etc.);
- transmission-related clearances;
- water sourcing agreement with the relevant water body, etc.;
- land-related approvals;
- permission from the relevant government regulatory authority for power required during construction;
- approvals for import of equipment to be installed at the project; and
- labour approvals.
This exercise is imperative not only to prevent potential roadblocks to the timely implementation of the project but also to prevent adverse financial implications through penalties or fines imposed by government authorities in the absence of the required consents or approvals. For example, in the Indian context, in the recent case of Common Cause v. Union of India,2 the Supreme Court of India imposed obligations on mine developers to pay compensation for carrying out mining operations without valid statutory clearances, and ordered the suspension of mining operations till the payment of compensation and the procurement of all applicable clearances.
Another aspect that is checked by the lenders is the corporate compliance of the SPV and the ability of the SPV to carry out the project (in consonance with its constitutional documents and corporate authorisations). In addition, it is a check to ensure that the lenders' rights are protected with regard to the shareholders.
iii Financing and security documentation
For a project finance transaction, typically, the following financing documents are negotiated between the lenders and the borrower.
FACILITY OR LOAN AGREEMENT
This records the detailed terms and conditions governing the financing facility being granted by the lenders. This agreement is executed among the lenders, the SPV and the security trustee (in the case of a consortium of lenders). Some of the main provisions included in a facility agreement are: the purpose of the facility, the rate of interest, disbursement-linked conditions, the amortisation schedule, the prepayment conditions, additional interest payouts for non-performance or delay etc., the security package, affirmative and negative covenants, representations, events of default, and the consequences of events of defaults, among others.
TRUST AND RETENTION ACCOUNT AGREEMENT
Because project finance transactions are based on the cash flows expected to be generated from a project, the lenders monitor and have recourse over all cash flows pertaining to the project. Accordingly, all project proceeds and project receivables are required to be routed through a trust and retention account (along with all sub-accounts) operating under a defined framework governing all inflows and outflows from the account. To record this understanding, a trust and retention account agreement (or escrow agreement) is entered to provide, inter alia, for appointment of a bank to act as a trustee for the benefit of all lenders, a detailed waterfall mechanism for the flow of the project proceeds into the various sub-accounts and the permitted withdrawals therefrom.
SECURITY TRUSTEE AGREEMENT
Typically, a security trustee is appointed by the lenders (being one of the lenders or a separate trust entity) in whose favour the entire security is created. This agreement is mainly required in consortium lendings. The security trustee agreement provides for the appointment of the security trustee and records its rights and obligations.
In consortium lending, an inter-creditor agreement is executed among the lenders, the lenders' agent and the security agent. Although the borrower is usually not a party to this agreement, the SPV is required to acknowledge it. The agreement mainly provides for:
- the process for enforcement of the security interest;
- the mechanism for the sharing and application of enforcement proceeds; and
- the provisions for the coordination and sharing of information among the lenders; inter alia, for the grant of waivers, credit rating of the SPV, etc.
FACILITY AGENT AGREEMENT OR LENDERS' AGENT AGREEMENT
In a consortium project finance, lenders appoint a lenders' agent for operational convenience and dealings with the SPV on behalf of all lenders. The facility agent agreement or lenders' agent agreement records the rights of the lenders' agent and the delegation of authority to the lenders' agent to act on behalf of the consortium.
iv Typical security package
The security package in a project finance transaction is largely limited to project assets and project receivables (with limited recourse to the sponsor or parent in most developing countries). On the other hand, corporate financing is based on the balance sheet level security (including cross collateralisation). Lenders funding projects typically require the following security package created through the security documents discussed in brief below:
- Movable assets – a charge on the project developer's movable assets and intangible assets created typically through a deed of hypothecation or indenture of mortgage.
- Immovable property – a mortgage over immovable property; the instrument for creating this mortgage is dependent on the requirements of local law. For example, in India a mortgage is created typically through the deposit of title deeds (an equitable mortgage) or through an English mortgage (i.e., where the property is transferred absolutely to the mortgagee, subject to a re-transfer obligation on repayment of the loan by the mortgagor), with the choice of mortgage depending among other things on the stamp duty payable on the instrument creating the mortgage, the state in India where the immovable property is located, the registration requirements, etc. The stamp duty on English mortgages (i.e., an indenture of mortgage) is ad valorem in India and higher than on an equitable mortgage.
- Current assets – a charge on all current assets including but not limited to book debts, operating cash flows, receivables, commissions, revenues created typically through a deed of hypothecation or indenture of mortgage.
- Bank accounts – a charge over a project developer's bank accounts (including control over the cash flows and the agreed waterfall for the cash flow, etc.) created typically through a deed of hypothecation or deed of charge or indenture of mortgage.
- Share pledge – a pledge over the promoter shareholding (both equity and quasi-equity instruments) in the SPV (it is either 51 per cent, 75 per cent or 100 per cent depending on the strength of the project or promoter) created by way of an instrument of pledge along with power of attorney.
- Project documents – a charge or assignment by way of security interest of all present and future rights, title, interest, benefit, claims and demand of the project developer on the project documents, insurance contracts etc., created pursuant to the indenture of mortgage.
- Sponsor support – the security package also includes sponsor support undertakings from the parent or sponsor of the SPV in most developing nations. The extent of the sponsor support is dependent on, inter alia, the credit profile of the promoter, the financial model of the project and the nature of the transaction. Usually, sponsor support undertakings are required to be provided for cost overruns that may be incurred by the SPV beyond the approved project cost; for the creation of a debt service reserve account to be maintained for the benefit of the lenders; to ensure the retention of ownership and management control of the SPV till the subsistence of the loan, etc.; to prevent the disposal of their shareholding in the SPV; and to address specific project-related risks such as the obligation to prepay loans in the case of underperformance (defined as the project not operating as per the banking base case). From a sponsor's perspective, the drafting of the sponsor undertaking is critical and it usually needs to ensure that its liability under the undertaking is capped and does not amount to a guarantee to prepay the debt in the case of the SPV's failure to repay. Further, where the promoter is a non-resident entity, compliance with the extant foreign exchange laws of the jurisdiction in which the project is located needs to be checked to determine if there are any approval requirements for the creation of such a pledge.
We now discuss in brief some of the main terms of the financing documents.
DRAWDOWN PROCESS – TYPICAL CONDITION PRECEDENTS
Some of the usual condition precedents (CPs) to the first drawdown of the loan are:
- the submission of corporate authorisations and certifications, which typically include relevant resolutions from the board of the borrower authorising borrowing and the related security creation, resolutions from the board of the parent providing security or executing a sponsor support undertaking, shareholder resolutions in connection with the borrowing of the SPV by its shareholders and shareholders of its parent depending upon transaction requirements and as may be required under the provisions of company law in the relevant jurisdiction;
- the submission of all project documents, project consents, approval, land documents, insurance contracts and any other regulatory requirements for the project being financed;
- the execution of financing and security documents;
- the submission of financial models, etc.;
- the perfection of security, although SPVs in recent times have successfully negotiated the creation of security in a phased manner with timelines identified in the financing documents, though in those cases the lenders usually cap the disbursement amount that can be availed pending perfection of entire security package;
- compliance reports or certificates from transactional advisers, such as engineers, lawyers, financial advisers and insurance advisers, that are usually retained by lenders to identify potential risks and ways of mitigation before disbursement; and
- the submission of documentary evidence of the infusion of funds by the promoter, because the projects are typically funded in a contractually agreed debt-to-equity ratio, where the equity component is either required to be infused upfront or in proportion to the disbursement amount being requested.
The process for seeking drawdown is also detailed in the facility agreement. Generally, the process requires submission of the drawdown request by the SPV, with supporting documents showing compliance with requisite CPs.
DETERMINATION OF DEBT AND EQUITY RATIO
One of the specific requirements for the grant of a project finance facility is to maintain a prescribed debt-to-equity ratio so that the approved project cost is funded in that agreed proportion. Typically, the debt-to-equity ratio varies between 70:30 or 75:25 or 80:20 depending upon the risk profile of the project, banking base case, promoter strength, etc. The borrower under the financing documents is required to maintain the prescribed debt-to-equity ratio throughout the tenure of the loan. In this regard, the lenders and the borrower usually negotiate as to what would constitute 'equity'; for example, would it be only pure equity shares issued by the SPV or also the quasi-equity instruments or shareholder loans (or both). Increasingly, over time lenders do allow quasi-equity instruments to be included in the definition of 'equity' primarily for commercial and tax reasons. However, if the promoter's contribution is infused by way of quasi-equity or debt (convertible and non-convertible debentures, and preference shares), any payment to the promoter on account of debenture redemption or coupon payments are subordinated to project finance lenders.
AMORTISATION SCHEDULE AND THE LOAN TENOR
The amortisation or repayment schedule contains the schedule of repayment of the principal loan amount advanced by the lenders. Usually, repayment of the principal amount is on a quarterly or half-yearly basis. The repayment instalments are agreed as either equal repayments or different repayments over the tenure of the loan. The latter approach is preferred when a cash flow mismatch is expected in the initial years of the project.
Typically, project loans have a tenor of 10–20 years including the construction period and the moratorium recognised in the loan agreement. The duration of the loan is ascertained based on the useful life of the project; for example, some power project loans are for a duration of 22–25 years as well. The borrower usually wants the repayment schedule to be commensurate with the life of the project. The loan tenor is usually finalised based on the project financials, etc. It is pertinent to mention that in some developing nations the central bank does provide some guidance on the tenor of the project loans to ensure that the repayment burden is spaced adequately to the life of the project.
A borrower is required to provide a number of representations to the lenders in the financing documents, regarding valid corporate existence, conformity with applicable law, adequacy of clearances required for the implementation of the projects, etc. As representations are subject to factual determination, it varies from case to case as per the nature of the transaction, the sector of borrower's operations, etc. Certain specific representations are also incorporated based on the findings of the due diligence exercise. Breach of a representation is treated as an event of default under the loan agreement.
Some of the typical representations in a facility agreement pertain, among other things, to valid corporate existence, compliance with applicable laws (including with respect to the environment and forest-related laws) and existing contracts, no security interest (other than as disclosed), no litigation (other than as disclosed), no default, representation on project documents, insurances, compliance with approvals, availability of all required approvals, no force majeure under the project contracts having occurred, and no defaulter in the board of directors.
Under the Loan Market Association (LMA) (which aims to develop industry practice and standard documentation), loan agreement representations provided by a borrower or obligor are typically required to be repeated on certain specified dates such as drawdown date, interest payment dates, repayment dates, etc. In the context of certain developing nations (such as India), the representations provided are typically required to be repeated on each day until the final repayment of the facility amount.
v Usual covenants
The facility agreement provides for affirmative covenants, negative covenants and financial covenants – we discuss each of these in brief below. These covenants are usually well negotiated between the borrower and the lenders.
Affirmative covenants primarily record the continuing obligations of the SPV. Some of the usual affirmative covenants include: compliance with applicable laws and clearances; the SPV's insurance and credit-rating obligations; the payment of taxes and other statutory dues; the lenders' right to inspect; the preservation of security; the constitution of the project management committee and audit subcommittee as required by the lenders; and the agreement to appoint an observer or lenders' nominee director on the board of the SPV. Further, information covenants such as the submission of audited accounts, information on ongoing or potential litigation, information on sale receivables are also incorporated as affirmative covenants. Information covenants also include, among other things, the periodic submission of information on the construction (the construction progress report), allowing periodic visits by the lenders on the project site (at the cost of the borrower), and furnishing reports by the lenders' consultants. This ensures that the lenders are able to monitor the construction and operation of the project and can determine if any action is required to be taken early on.
Negative covenants prohibit the SPV from doing certain acts that are considered prejudicial to the lenders' interests, such as transferring assets, granting or issuing security, and incurring indebtedness (other than in favour of project lenders). Some of the typical negative covenants that would require the lenders' prior written consent include a change in management or board composition; a change in control of the SPV (at times, lenders also restrict any change in shareholding of the SPV); the sale, transfer, lease or disposal of the assets of the SPV; the creation of security or encumbrance other than as provided in the facility agreement; incurring indebtedness, extending loans or undertaking guarantee obligations, other than as provided in the facility agreement; payments to the promoter either by way of dividend distribution, or coupon or interest payment; repayment of promoter loans; alteration to the constitutional documents; and an alteration in the shareholding pattern.
RESTRICTED PAYMENTS CONCEPT
Any dividend distribution by the SPV is allowed by the lenders only on satisfaction of certain prescribed restrictive payment conditions such as: no default being in place; that all due interest payments and repayment instalments have been paid; that the commissioning of the project has been achieved; and that there is compliance with prescribed financial ratios, with the debt service reserve amount and any other reserve amounts for the operations of the project having been created. In addition, lenders also at times provide that any dividend distribution would only be subject to the prior consent of the lenders.
The repayment of quasi-equity instruments such as non-convertible debentures, or the payment of interest or the principal amount of shareholder loans is usually subordinated to project finance lenders. However, in certain instances lenders may agree to repayment of interest on debentures or shareholder loans being permitted subject to their prior consent and the prescribed restricted payments conditions being met.
Financial covenants are an important aspect of the financing agreements and effectively reflect the financial health of the SPV and sustainability of the lenders' exposure. Some of the most common financial covenants included in the loan agreement include debt service coverage ratio (which evidences the serviceability of the financing), debt-to-equity ratio and fixed asset coverage ratio. The method of computation of each of these financial covenants along with the specific definitions are commercially agreed and incorporated in the facility agreement. Financial covenants are typically monitored on a year-on-year basis pursuant to information provided in the audited financial statements by the borrower; with the first testing of these financial ratios being at the end of one full year of operation of the project. Non-compliance with the agreed financial covenants thresholds usually entitles the lenders to charge additional interest, change the pricing of the loan (margin or spread) and declare an event of default.
EVENTS OF DEFAULT AND CONSEQUENCES THEREOF
The facility agreement provides for a list of borrower's events of default that entitle lenders to exercise certain rights such as the right to accelerate repayments and enforce security interests. Some of the typical events of default provided for in a facility agreement include non-payment of principal or interest, non-compliance with covenants, misrepresentation, inadequacy of security, invalidation of clearances or government approvals, change in control, breach of applicable laws, breach of financial covenants, and initiation of insolvency proceedings. An important question with regard to events of default is whether a cure period is to be provided to a borrower. While lenders usually do not agree to blanket cure periods for all events of default, cure periods for specific events are generally negotiated and included.
Upon the occurrence of an event of default, the lenders (subject to the provisions of the inter-creditor agreement in consortium funding) are entitled to exercise any or all of their rights to the enforcement of the security interest; the acceleration of repayment; and the conversion of outstanding debt into equity shares (if provided for in the facility agreement). Additionally, the lenders are entitled to exercise all their rights under the applicable law. In the Indian context, for example, that would include takeover of the management of the borrower under the Securitisation and Asset Reconstruction and Enforcement of Security Interests Act, 2002, initiation of insolvency proceedings under Insolvency and Bankruptcy Code, 2016, and taking steps or corrective measures under the regulatory framework provided by Reserve Bank of India such as the Prudential Framework for Resolution of Stressed Assets dated 7 June 2019.3