- Credit — Capital markets
7.01 Project financings can be, and often are, document-heavy transactions because of the elaborate risk allocation and mitigation measures they engender. Any project financing will generate volumes of documentation addressing the project’s construction and operation, the financing that supports it, and the security that underpins the financing—a complex project financing will generate even more.
7.02 The financing arrangements between the project company (i.e. the borrower) and the lenders will be recorded in a suite of bespoke documents tailored to the needs of the particular transaction and its various stakeholders. Needless to say, the complexities of the projects themselves, coupled with the differing interests and objectives of the participants, (p. 161) make the exercise of documenting the contractual arrangements anything but straightforward, with the result that it is difficult and time-consuming to ensure that there are no ‘holes’ in the contractual arrangements arising from things being overlooked (or, more likely, not fully developed). Since shortcomings in the contracts will generally work to the disadvantage of everyone concerned (because, at best, they can lead to disputes that take time to resolve), considerable care must be taken to ensure that the parties’ commercial bargains are fully, and accurately, recorded.2
7.04 The credit agreement is the principal legal document that formally records the express terms3 agreed by the project company and the lender to govern their contractual relationship and the lending arrangement. At the most basic level, the credit agreement will detail (a) the circumstances in which the lender is obliged to lend a sum of money to the project company and (b) the project company’s obligation to repay that sum (and, at least usually,4 to pay interest thereon until it does so). These core obligations will be supplemented by a number of protective and administrative provisions dealing with conditions precedent, representations, covenants, events of default, agency mechanics, and dispute resolution processes.
7.05 Market practice and a desire on the part of arrangers and originating lenders to syndicate all or part of the loan are important factors when it comes to deciding on the basic form of the credit agreement, with the result that English law-governed project finance credit agreements are often based on the leveraged form of credit agreement published by the London Loan Market Association (LMA), albeit with considerable adaptation to suit the particular transaction.5
7.06 Project financings are increasingly complex and in many cases involve multiple tranches of debt (sometimes in different currencies) from a number of different lenders or lending groups. In these multi-sourced financings, it has become customary for the provisions that (p. 162) are common to each tranche of debt to be set out in a ‘common terms’ agreement. The commercial and operational features that are unique to different tranches of debt are then set out in individual (and often more streamlined) credit agreements. The use of a common terms agreement saves time and cost by avoiding multiple bilateral negotiations in relation to provisions that are substantially the same. It also ensures lender parity, at least to the extent of the common terms, and, perhaps most importantly, reduces the risk of terms being construed inconsistently across tranches, particularly where the agreements that regulate those tranches are governed by different laws.
7.07 Project financing credit agreements are broadly similar to credit agreements seen in other financings, with a few (but critical) differences, some of which are explored later in the chapter.6 Detailed checklists of a number of typical conditions precedent, representations, covenants, and events of default included in project financing credit agreements are set out in Appendix 1.
7.08 Credit agreements for project financings will customarily prescribe the purpose for which loans advanced thereunder may be applied. The lenders will want to ensure that the project company does not divert monies advanced under the facility away from the project (because doing so increases the risk that there will be insufficient funds to complete the project) and that they are in a position to demonstrate compliance with any lending eligibility requirements they may have.
7.09 Although use by the project company of sums advanced under the credit agreement for an unauthorized purpose will invariably constitute an event of default, the inclusion of a purpose clause in a credit agreement governed by English law can also provide the lenders with an additional protection in cases where a project company becomes insolvent after receiving an advance but before it has applied the proceeds to the specified purpose.7 This is because under English law a borrower holds the proceeds of a loan which is to be applied for a specific purpose on trust for the lender until those proceeds are so applied. In these circumstances, the lender is entitled to prevent the application of the proceeds for any other purpose, with the result that if the borrower becomes insolvent, the proceeds do not form part of the borrower’s general body of assets available to meet the claims of its unsecured creditors but, rather, are held for the exclusive benefit of the lender.8
7.10 The credit agreement will generally become effective once it is signed by each of the parties. However, the obligation9 of a lender to lend the agreed sums of money to the project company will typically be subject to the satisfaction (or waiver) of a number of further conditions. These will be specified in the credit agreement and labelled ‘conditions precedent’. In transactions where there are different tranches of debt, there will usually be conditions precedent which are common to all debt tranches and are therefore set out in the common terms agreement and separate sets of conditions precedent which are specific to particular debt tranches and are therefore set out in the relevant individual credit agreements. Conditions precedent are usually divided into those applicable to the initial drawdown of loans and those applicable to all drawdowns.
(1) the project company and any other relevant contract counterparties (such as guarantors, sponsors, and material project participants) are duly authorized to do everything they need to do in terms of the development, operation, and financing of the project;
(2) the project satisfies all requirements imposed by the lenders and their advisers as a result of the lenders’ due diligence;
(3) the project complies with applicable laws and governmental permits;
(4) the project is forecast to meet the agreed financial ratio requirements; and
(5) all material project and finance documents (including security documents) have been entered into and are binding and enforceable against the parties thereto (or, in the case of agreements (e.g. marketing agreements) that will only be needed at a later date, are in an agreed form).
7.12 Conditions precedent to each subsequent drawdown are designed to give the lenders the opportunity to reassess whether they wish to continue with the project (and, if so, whether they wish to do so on the same or different terms) in circumstances where there has been a material deterioration in its risk profile. This is achieved by having conditions that require evidence or suitable confirmations to the effect that:
(1) agreed construction milestones are being met as scheduled and on budget;10
(2) the project has not encountered any environmental, technical, or other unexpected complications;
(3) applicable financial and other forecasts continue to show that the project will meet the agreed financial ratio requirements;
(4) no other material adverse events affecting the project have occurred since the last drawdown;
(6) no event of default (or ‘potential’ event of default11) is continuing.
7.13 If something has happened as a result of which any of the conditions precedent to subsequent drawdowns cannot be met (a state of affairs that is often referred to as a ‘drawstop’), the project company will need to request the lenders to waive that condition before it will be able to borrow further funds for the project. In all but the most extreme cases (when the lenders decide not to put further money into a project and are probably then forced to write off all the loans that they have made up to that point), the lenders will grant the requested waiver. However, it is likely that before agreeing to do so, they will seek additional information or assurances from the project company or its shareholders with respect to the problem that has arisen. By including the conditions precedent to subsequent drawdowns the lenders will (if the conditions are not met) be entitled to make requests for the additional information or assurances even in cases where they do not have a specific entitlement to do so and without themselves being at risk of breaching their obligations under the credit agreement if they decline to advance funds until they have received the requested information or assurances.12
7.14 The credit agreement will usually require that the initial conditions precedent documentation or evidence be ‘in form and substance satisfactory’ to the lender (or all of them in the case of a syndicated facility13). The conditions precedent to subsequent drawdowns will generally only have to be met to the satisfaction of (or waived by) a prescribed majority of the lenders in the syndicate, although it may be that particular lenders will insist on a veto right in relation to particular conditions precedent.14
(p. 165) 7.15 Although syndicated credit agreements sometimes state that conditions precedent documents must be satisfactory to the lenders’ agent, the inherent liability risks associated with an agent giving the requisite confirmation are such that agents are likely to be unwilling unequivocally to confirm or certify satisfaction of the conditions precedent without being instructed to do so by the lenders.15 As the agency provisions in the documentation will invariably permit an agent to seek instructions from the lenders with respect to the exercise of discretions (such as the approval of conditions precedent documentation), a project company will in practice gain little by insisting on the agent being the person responsible for signing-off on conditions precedent (and by the same token the lenders lose little by conceding the point).
7.16 It is not uncommon for lenders’ counsel to provide some level of comfort as to the satisfaction of the initial conditions precedent for a transaction. This will normally be done by means of a qualified letter to the effect that the project company has delivered documentation and evidence which, on its face, appears to conform to the applicable requirements of the credit agreement. The extent of the qualifications in the letter will depend on the particular transaction, but counsel will clearly not be in a position to issue a confirmation with respect to factual matters, technical reports, the financial model, and comparable items.
Drawdown of loans
7.17 Once the conditions precedent have been satisfied (or waived), the project company will be entitled to request that funds be disbursed by delivering written requests (usually in a prescribed form) in accordance with whatever procedures are set out in the credit agreement. The delivery of a drawdown request will (if all applicable conditions have been satisfied or waived) oblige the lenders (severally in proportion to their respective participations in the credit facility)16 to make the requested disbursement of funds. The project loans will usually be disbursed in a number of separate advances throughout the availability period specified in the credit agreement (which will itself be linked to the project’s anticipated construction period). Lenders will always require a minimum period of notice to raise the (p. 166) funds, whether in the interbank market or otherwise. Although the notice period is negotiated, it will largely be driven by the customary practice of the relevant interbank market. The minimum period of notice is usually in the order of five business days.17
7.18 A drawdown notice will usually be stated to be irrevocable and will typically oblige the project company to pay breakage costs incurred by a lender if the advance requested in that notice is not made for some reason, as would be the case where, after its receipt of the drawdown notice but before the requested advance is made, the lender becomes aware of the occurrence of an event of default or some other specified ‘drawstop’ event that entitles the lender to withhold funding.
7.19 The project company will want to ensure that the drawdown mechanics are as flexible as possible so that it is able to make drawings in line with its actual and anticipated cash requirements and minimize negative carry costs—i.e. the difference between the cost to it of borrowing funds from the lender as compared with the interest it will receive in respect of funds deposited pending payment to the ultimate recipient. The lenders, on the other hand, will want to minimize the administrative burden associated with the disbursement of funds and will seek to introduce minimum amounts for individual drawdowns, limits on the frequency of drawings, and limits on the overall number of loans that may be outstanding at any one time.
7.20 In a multi-sourced financing, logistical considerations will often drive the project company to request that funding be made through a single lenders’ agent, a practice which, albeit normally accepted, exposes the lenders to a risk of the agent’s insolvency for however long funds remain in the agent’s possession. It is, however, now common practice for credit agreements to attempt to mitigate the risks associated with the insolvency of agent banks by including provisions that facilitate the making of payments direct from lenders to borrowers (and vice versa) (or, in appropriate cases, through trust accounts) and at the same time allow an agent to be replaced by the majority lenders without the agent’s cooperation.18
Contractual recognition of ‘bail-in’
7.21 In recent years, the syndicated loan market has been required to address the requirements of Article 55 of Directive 2014/59/EU (commonly known as the Bank Resolution and Recovery Directive (BRRD)). Broadly speaking, the BRRD establishes a framework to enable national regulators to recover and restructure distressed and failing financial institutions that are established within the European Economic Area (EEA)19 with a focus on minimizing reliance on the use and availability of public funds. The BRRD gives EEA regulators a range of tools to do this, including the power to write-down and/or convert all or part of the liabilities owed by a failing institution into equity20 (these powers are generally referred to as ‘bail-in’ powers or the ‘bail-in’ tool).21
(p. 167) 7.22 As a matter of law, the exercise of these ‘bail-in’ powers is effective under any document governed by the law of an EEA country irrespective of the terms of that document. However, the BRRD does not apply outside the EEA; consequently, there is a risk that a creditor could challenge the operation of these powers in the courts of a non-EEA jurisdiction; particularly if the contract under which the relevant liabilities arise is governed by the law of a non-EEA country.22
7.23 Article 55 of the BRRD seeks to address this risk by requiring institutions to include a provision in contracts whereby the counterparty expressly acknowledges and agrees that the institution’s liabilities under such contract may be subject to the BRRD ‘bail-in’ powers. Article 55 is a safeguarding provision: a failure to include it does not necessarily preclude the regulators from exercising their bail-in powers nor does its inclusion guarantee that the exercise of such powers will not be challenged in a non-EEA jurisdiction. However, it is generally believed that the inclusion of an express acknowledgement as to the potential exercise of the ‘bail-in’ powers will render the exercise of such powers less susceptible to challenge.
(1) contracts creating liabilities that are entered into by an EEA financial institution on or after 1 January 2016;23
(2) contracts to which an EEA financial institution is party that are subject to a ‘material amendment’24 (irrespective of when the contract was originally executed); and
The BRRD has a wide-reaching scope and will apply to any contractual and non-contractual liabilities that the relevant EEA financial institution may have under the non-EEA law governed document. Some of the most obvious examples are lending commitments and indemnities. However, the BRRD would also apply to potential liabilities for non-contractual claims (such as negligence or misrepresentation) and administrative liabilities (e.g. confidentiality obligations, requirements to obtain borrower consent, and information covenants). Although the BRRD does contain certain exclusions, these are not typically relevant in the context of project finance documentation.
7.25 Virtually all project financings involve liabilities resulting from agreements governed by the law of a country outside of the EEA25 and it is relatively common for multi-sourced project financings to involve at least one EEA-established financial institution.26 As a result, most non-European institutions have accepted ‘bail-in’ as a regulatory risk in doing business with European lenders and most European lenders will not proceed without an appropriate ‘bail-in’ clause being included in the relevant document(s).
7.26 European regulations specify the mandatory features of any ‘bail-in’ clause.27 A number of industry bodies (including the LMA, the Loan Syndications and Trading Association (LSTA),28 the Association for Financial Markets in Europe (AFME), the International Capital Markets Association (ICMA), and the International Swaps and Derivatives Association (ISDA)) have produced model Article 55 ‘bail-in’ clauses that are designed to comply with those features and which, for time and cost-efficiency, are heavily relied upon in the market. It is rare for entirely bespoke provisions to be drafted, but these ‘model’ provisions are intended to be starting points only and it is likely that these will continue to be negotiated on a transaction-by-transaction basis and it will be particularly important to determine whether the ‘bail-in’ provision will be effective under the relevant non-EEA law.
7.27 Project finance loans typically have tenors that reflect the credit profile of the relevant project, which as a rule means that their tenors are longer than those for ordinary corporate loans. Whilst project finance loans will normally amortize over time on the basis of semi-annual repayments set by reference to a specified percentage of the amount of the loan at (p. 169) completion, the repayment profile of a project finance loan will usually be ‘sculpted’ by reference to the anticipated cashflows of the particular project as reflected in the initial financial model, with the result that repayment schedules will often reflect anticipated fluctuations in a project’s production—and, in consequence, its revenues—resulting from, for example, seasonal variations in demand for that production or reductions in the project’s output capacity during periods of major maintenance.
7.28 Credit agreements for projects with variable revenue streams often include ‘cash sweeps’, such that where a project generates higher than anticipated cashflows over a specified period, a proportion29 of the cashflow that would otherwise be available for distribution to shareholders is applied to make prepayments of the project’s debt. Cash sweep mechanisms are usually included with the other ‘mandatory’ prepayment provisions discussed in paragraph 7.37. However, it is also quite reasonable to classify them as ‘soft’ repayment obligations because both lenders and project companies will generally expect a project to perform better than assumed for the purposes of the financial model by reference to which the repayment schedule has been set.
7.29 Where revenues are particularly volatile, the credit agreement could allow the project company to defer some of its principal repayments during lean periods and then ‘catch up’ with the repayment schedule when the project’s revenues permit. Whilst the charters and policies of many public and multilateral agency lending institutions are such that they have little or no scope for agreeing to anything other than a repayment schedule with equal semi-annual instalments, other lenders are often more flexible if the circumstances so warrant. However, even where lenders are flexible, there will be limits on the extent and duration of deferrals, not to mention a prohibition on the making of distributions whilst the deferrals continue. Such deferral mechanisms are also likely to be coupled with an arrangement (which would be linked to the cash sweep prepayment mechanism discussed in paragraph 7.28), whereby, before being applied to make prepayments, excess cashflows must be applied to fund special reserves that will be available to the project company to fund expenses during periods when cash inflows are lower, or cash outflows higher, than the norm.30
7.30 The credit agreement will usually require the project company to repay the loans by making payments to the lenders’ agent for distribution to the lenders. As a general rule, the project company’s repayment obligation is discharged at the time of its payment to the lenders’ agent, whether or not the agent then distributes the payment to the lenders and whether or not there is a specific statement to this effect in the credit agreement.
Prepayments and cancellation
7.31 The repayment schedule included in any credit agreement reflects how the parties anticipate the relevant loan will be repaid if everything goes according to plan. This is the (p. 170) case even where the repayment schedule is ‘sculpted’ to reflect the vagaries of a project’s cashflows, as discussed in paragraph 7.27. No amount of planning, however, will cover every eventuality, particularly in relation to a project financing transaction. Things can go wrong and circumstances can change, sometimes for the good, sometimes not.
7.32 When things go wrong, the regime that applies to the repayment of the loan is that regulated by the events of default provisions of the credit agreement (as to which see paragraphs 7.102 to 7.109). The events of default regime is not, however, appropriate in cases where there has been a change in circumstances rather than something having gone wrong, with the result that credit agreements will usually include prepayment provisions. These entitle the project company to repay some or all of the loan early by making voluntary prepayments (because, at least in the case of a credit agreement governed by English law, in the absence of an express right a borrower needs the lenders’ consent to make a prepayment). They also entitle lenders to call for mandatory prepayments in circumstances such as those discussed in paragraph 7.37.
7.33 Voluntary prepayments will be conditional on the project company giving a minimum period of notice (although as a general rule this period will be reasonably short), more often than not given so as to require the prepayment on the last day of an interest period in order to minimize the administrative burden associated with the calculation of breakage costs and the potential for a mismatch with interest hedging arrangements that may have been put in place in parallel with the lending arrangements. In a syndicated transaction, voluntary prepayments will be required to be made to the lenders pro rata unless circumstances have arisen that make it reasonable for the project company to prepay a particular lender but not others. By way of example, a credit agreement will usually give a project company the option to pay a particular lender where payments to that lender must be grossed-up to negate the effect of withholding tax on interest payments or where it has made a claim under the tax indemnity or increased costs clauses. Increasingly, rights to prepay particular lenders are included in syndicated credit agreements to allow a project company to prepay a particular bank which is refusing to grant its consent under the credit agreement in circumstances where a substantial majority of the lenders have given their consent.31
7.34 Provisions allowing the prepayment of particular lenders are normally coupled with mitigation provisions that contemplate the lender moving its lending office or transferring its participation in the loan to an affiliate or one or more other lenders (whether or not within the syndicate), not least because the fact that the project company has finite cash resources will mean that it may not have the cash available to make a prepayment in these circumstances.
(p. 171) 7.35 Prepayments made during the availability period of a credit facility (and cancellations of undrawn commitments to lend) are likely to be a good thing because they will result in a project with a lower debt burden. However, to minimize the risk of problems in achieving project completion as a result of a shortage of funds, the project company’s rights of prepayment and cancellation prior to completion will generally be conditional on its delivery of a formal certificate confirming that it will have sufficient committed funding (after the prepayment or cancellation) to complete the project without a need to incur additional debt (or to receive further funds from shareholders).
7.36 Some lenders request a prepayment fee or premium if a loan is repaid early (whether or not the prepayment is voluntary or mandatory) on the basis that, having incurred costs (in the form of internal management time rather than out-of-pocket expenses, which are generally reimbursed) in relation to their investment in anticipation of receiving an income stream over the medium to long term, they will need a minimum period in which to recover their costs. A prepayment fee achieves this because it provides the lenders with an alternative return in circumstances where they would otherwise have received their return through the agreed interest margin. Project companies, on the other hand, maintain that the front-end fees paid to lenders are designed to compensate lenders for these costs and argue that the flexibility to make prepayments is central to the efficient management of a project’s finance plan, pointing out that this flexibility is one of the key reasons for preferring bank loans over capital markets debt issuances.32
7.37 Mandatory prepayment provisions are included in credit agreements because circumstances can change in a way that makes it reasonable to require a project company to repay a particular lender or to reduce the overall amount of the loan, or to give individual lenders the right to require that their participation in the loan be repaid. The cash sweep mechanism discussed in paragraph 7.28 is a classic mandatory prepayment provision and operates to allow the lenders to share the benefits generated by a project that performs better than assumed in the base case model. Other changes in circumstances that trigger mandatory prepayment obligations include:
(1) Illegality: where it becomes illegal for a lender to lend or otherwise participate in the facility, the credit agreement will oblige the project company to repay that lender’s share of the loan. However, as with the voluntary prepayment provisions triggered by grossing-up obligations and tax indemnity and increased costs claims as mentioned in paragraph 7.33, mandatory prepayment obligations arising as a result of illegality are generally coupled with mitigation provisions that contemplate the lender changing its lending office or transferring its participation in the loan to an affiliate or another lender. The credit agreement will also generally provide that the repayment need only be made at the end of the maximum grace period permitted by the relevant law.
(2) Change of control: where the equity participations of the original sponsors of a project fall below a minimum threshold (or where a single person or group of persons acquires control of the project company) credit agreements often give individual lenders (p. 172) the right to require repayment of their share of the loan on the basis that whilst the identity of those that control the project company is of critical importance to lenders, the particular change of control may concern some lenders more than others (and some not at all). However, most project financings deal with change of control issues through the more specific shareholding retention covenants that are included in the equity support documentation (as to which see paragraphs 12.42 to 12.44).
(3) Extraordinary recoveries: where nationalization compensation proceeds are received by a project company in relation to a particular project asset (for example, a supply pipeline or port facilities) or where a project company receives insurance proceeds as a result of the destruction of a capital asset which it decides not to replace (or which the credit agreement does not permit it to replace, for example where replacement requires the lenders’ consent and that consent is not forthcoming), the credit agreement will require that the proceeds (if over a prescribed minimum) be applied in prepayment of project debt because, in both cases, the project is likely to have a smaller asset base as a result of the event giving rise to the proceeds (and so be facing the prospect of revenues lower than it would have been able to generate had the event not occurred).33 Liquidated damages paid under construction contracts as a result of poor performance34 are also likely to be required to be applied to a prepayment on the same basis (because the income from the project will fall in line with its reduced output capacity).35
(4) To cure financial ratio breaches: generally speaking, any failure by a project company to meet its financial ratios on a testing date will constitute an event of default. Credit agreements now typically include provisions that give project companies the right to remedy (or avoid) breaches of financial ratios by prepaying debt and/or procuring the injection of new equity, although lenders may impose limits on the number of occasions on which such provisions are used.
(5) Sanctions etc.: credit agreements for project financings often include specific representations and covenants to reflect sanctions laws and regulations in the jurisdictions where the lenders are incorporated or do business; a breach of such provisions will almost invariably trigger an obligation to repay all the lenders.36
(p. 173) 7.38 The credit agreement will stipulate how partial prepayments will affect the project company’s scheduled repayment obligations. Voluntary prepayments may be applied against the repayment schedule in inverse chronological order (so that the final repayment instalment is reduced to zero before any other instalment is affected). This is the approach preferred by lenders because it shortens the average life of the loan. However, voluntary prepayments are more frequently applied pro rata against all future instalments (and sometimes, but more rarely, as the project company may elect37). Mandatory prepayments attributable to a cash sweep are in many ways akin to voluntary prepayments, with the result that, although usually applied against the repayment schedule in inverse chronological order, they are often applied pro rata against all future instalments, and occasionally as the project company may elect.
7.39 Mandatory prepayments of individual lenders affected by illegality should obviously be applied pro rata to all future instalments; so, too, should prepayments made with insurance proceeds where, for example, part of a project’s plant and machinery has been destroyed but the project company has decided against wholesale reinstatement. Whilst in both these cases the prepayment is applied in the same way, the reason that this is so is different. In the former case, the prepayment is applied against the repayment schedule so that the prepayment of amounts owed to the lender that is affected by the illegality has no impact on the other lenders; in the latter case, the prepayment is applied so that, going forward, the project company’s repayment obligations are reduced in line with what is assumed to be the reduction in the revenue-generating capacity of the (now smaller) asset base of the project.
7.40 Apart from those structured to comply with Islamic financing principles (as to which see Chapter 11), credit agreements will in almost every case38 impose an obligation on the borrower to pay interest on the loans that have been made to it, whether the interest is calculated at a fixed rate or, more commonly, at a floating (i.e. variable) rate, where the interest rate is reset for successive, relatively short, interest periods by reference to market rates such as the London interbank offered rate (LIBOR)39 throughout the life of the (p. 174) loan.40 The assumption that underpins floating rate loans is that the lenders ‘match fund’ their participations in the loans by taking short-term deposits in the relevant market. The borrower is then charged interest on the loans at a specified rate above the market rate for the applicable interest period. The margin thus represents the lenders’ yield for accepting the project company’s credit risk and will vary depending on the lender’s risk assessment, which, as well as being different for different project companies and different projects, may also vary with changes in the project company’s financial health from time to time or events such as completion of the project.
7.41 Market rates are usually set by reference to a screen rate service such as Reuters, with a fall-back to an alternative rate-setting mechanism (or mechanisms) should the screen service be unavailable. Historically, quotations from nominated ‘reference banks’41 was the preferred fall-back if a screen rate service was unavailable. However, credit agreements are now more likely, in the first instance, to provide that if the interest period for which an interest rate is required to be determined is not of a duration that matches the available screen rates, then the rate will be determined by linear interpolation between the screen rates for the two periods whose duration is closest to that of the interest period for which the rate is required. They may then include reference bank rates as a further alternative rate setting mechanism that operates before the market disruption provisions discussed in paragraphs 7.46 to 7.49 are triggered.
7.42 To ensure that margins in floating rate credit agreements are protected at times when the interest rates in the relevant interbank market are negative, lenders will usually wish the interest calculation provisions in such agreements to deem the interbank rate to be zero should it in fact be lower than that for any relevant period. Whilst this ‘zero floor’ is still generally accepted by project companies, it is becoming increasingly common for borrowers to attempt to resist its inclusion. If the lenders are prepared to accept that the ‘zero floor’ should not apply, it is likely that they will insist on limiting the benefit of any negative interbank rate to the amount of the margin in order to ensure that they do not have to make payments to their borrowers.
7.43 In most cases, a project will not be revenue generating during the construction period, with the result that interest that is not paid from the proceeds of equity contributions will need (p. 175) to be paid from either drawings under the credit agreement (in which case financing costs will be included in the definition of project costs) or capitalized and so added to the principal of the loan. Interest is sometimes capitalized automatically as and when it falls due, but lenders often require that a drawdown request is submitted in respect of the capitalization of interest so that, if the conditions precedent to a utilization of the facility are not satisfied, capitalization will not occur and the interest will need to be paid from other sources.
7.44 A failure by the project company to pay any sum due from it under the financing documents will constitute a payment default for the purposes of the events of default section of the credit agreement and will also trigger an obligation to pay default interest on the unpaid sum. Default interest is usually expressed to accrue at a specified rate (typically in the range of 100 to 200 basis points) higher than the rate that would have applied to the unpaid sum had it been an advance made under the credit agreement. Fixed-rate loans are likely to impose default interest calculated at a floating rate (although this is by no means an invariable rule), in particular because a floating rate is more likely to reflect the lenders’ actual losses attributable to the non-payment.
7.45 It is worth noting in this context that the obligation to pay default interest is effectively an obligation to pay liquidated damages—the project company’s non-payment of an amount on its due date is a breach of contract and the interest is payable as a result of the breach. This being so, the obligation to pay default interest could be rendered unenforceable by the English rules on contractual penalties, the basic rule being that a contractual provision that imposes a detriment on a party as a result of a breach of the contract will be a penalty, and as such unenforceable, if the provision constitutes a secondary obligation (i.e. one that arises on a breach of a primary obligation under a contract) and the detriment is out of all proportion to the innocent party’s legitimate interest in the enforcement of the (primary) obligation that has been breached.42 Thus, the greater the differential between the default and non-default interest rates, the greater the risk of the obligation to pay default interest being held to be a penalty. That said, it is unlikely that an uplift of the default rate in the order of 100 to 200 basis points could be successfully challenged on this basis.
7.46 As a rule, the interbank rates used as the benchmark for setting interest rates on floating rate loans reflect the lenders’ costs of funding their participations in those loans. However, to cater for situations where this is not the case, most credit agreements include a so-called market disruption clause which ensures that the lenders’ actual cost of funding their participations is used as the base reference rate for the purpose of setting the interest rate on the loans to the project company.
7.47 The market disruption clause will generally be triggered if the relevant interbank rate cannot be established at all or if a significant proportion of the lenders in a syndicate43 find that their cost of funding their participations in the loans is higher than the interbank rate (p. 176) established by the normal means applicable under the credit agreement. The minimum threshold is intended to ensure that the clause only operates in cases where the problem is attributable to a genuine market problem rather than, for example, a falling credit rating of a particular lender.
7.48 If the market disruption clause is triggered, each lender will be entitled to be paid interest at a rate calculated by reference to its cost of funding its participation in the loan from whatever source it may reasonably select, pending agreement on an alternative basis for calculating interest going forward.
7.49 Even though market disruption clauses are almost invariably included in credit agreements, lenders tend to be reluctant to invoke the clause. The reasons for lenders’ reticence include a reluctance to be seen to have higher than average funding costs (because higher funding costs are a reflection of the market perception of their credit risk) and an unwillingness to disclose funding costs for competitive and reputational reasons. The continuing importance of this clause is thus in practice more likely to be limited to circumstances where loans are being advanced in less convertible currencies.
7.51 More specifically, a project company will generally be required to make payments to the lenders that are designed to protect the lenders against the impact of withholding and other taxes on payments in respect of the loans (excluding taxes calculated by reference to the lenders’ ordinary net income) and against increases in the cost to the lenders of making the loans insofar as those increases are attributable to changes to the regulatory regimes to which the lenders are subject.
7.52 As discussed in paragraphs 7.34 and 7.37, where circumstances have arisen that oblige, or will oblige, the project company to make a yield protection payment, the credit agreement will usually require the relevant lender to mitigate the impact of those circumstances by changing its lending office or transferring its participation in the loan to an affiliate or to another lender in the syndicate, and, at the same time, and by way of an exception to the equal treatment paradigm that underpins most credit agreements, entitle the project company to prepay the affected lender’s share of the loans.
7.53 Whilst there are circumstances44 in which a lender may be prepared to accept payments of interest on a loan net of any withholding tax imposed by the taxing authorities in the jurisdiction in which the project company is located, that is very rarely the case. As a result, for a lender, a tax gross-up clause is almost always a non-negotiable prerequisite of any credit agreement. The gross-up clause shields lenders from the effects of the imposition45 (p. 177) of withholding taxes on interest and other payments by requiring the project company to make the payments in full as if there had been no withholding.
7.54 As well as the mitigation measures mentioned in paragraph 7.52, the tax gross-up clause may also impose ‘soft’ obligations on lenders to pass the benefit of tax credits attributable to the withholding that they are able to obtain against their own tax liabilities back to the project company. However, such provisions will expressly stipulate that the lenders are to have completely unfettered rights to determine how they deal with their own tax affairs and (unsurprisingly) give the project company no rights to become involved with these determinations. Where a financing features an A/B-loan structure,46 the tax gross-up may be extended to deductions on the onward payments to the B-loan participants.
7.55 A project company will also be required to indemnify the lenders against taxes imposed on or in relation to sums that they may receive under the credit agreement. The indemnity will not, however, extend to taxes on net income imposed in a lender’s jurisdiction of incorporation or residence, or the location of its lending office.
7.56 Since 2010 the non-US syndicated loan market has been required to address US tax legislation known as the Foreign Account Tax Compliance Act (FATCA),47 which may impose a 30 per cent withholding tax on a broad range of payments, including certain payments by non-US persons. Payments that are within FATCA’s ambit include US source interest, which could include interest paid by a non-US borrower in certain, relatively unusual circumstances,48 and gross proceeds from a sale or other disposition of US shares and debt instruments (e.g. repayment of principal as well as proceeds paid to a security agent in the course of enforcement proceedings).49 Foreign financial institutions (FFIs) that comply with the FATCA regime may additionally be required to withhold tax from ‘passthru payments’ they make to other FFIs in certain circumstances.50 Passthru payments, which can include interest payments and payments under derivative contracts, do not require a US source to be subject to this withholding.51 Under transition rules, withholding with respect to the different categories of withholdable payments will be phased-in gradually by 2019, and certain instruments are grandfathered, as explained in paragraph 7.58.
7.57 A central objective of FATCA is to force FFIs to disclose details of US investors and account holders to the US Internal Revenue Service (IRS). Broadly speaking, this objective is achieved through a 30 per cent withholding tax on withholdable payments unless the FFI discloses the requisite information to the IRS and otherwise complies with the FATCA regime.52 FFI is broadly defined for these purposes53 and would include most, if not all, of the lenders in a standard project finance transaction. As a general matter, therefore, if a (p. 178) non-US borrower makes payments of interest for the benefit of a non-US lender and the payments are otherwise withholdable under the FATCA regime, the lender would only be able to receive those payments free of FATCA-related withholding if it complied with the regime.
7.58 FATCA-related withholding will not apply if the credit agreement and the loans drawn under it are ‘grandfathered’, which will generally be the case if the loan obligations are entered into on or before, and not materially modified54 after, 30 June 2014.55 In addition, FATCA-related withholding applicable to non-US source payments under the passthru regime mentioned here is subject to its own grandfathering regime.56 Even if a loan is not grandfathered, withholding under the FATCA regime will only be relevant if the effective date for that withholding has occurred, which is 1 January 2019 for passthru withholding57 and withholding under the ‘gross proceeds regime’,58 and 1 July 2014 for US-source interest and other US-source withholdable payments.59
7.59 Local law restrictions on FATCA reporting, withholding, and account closure requirements would have made it difficult, if not impossible, for certain FFIs to comply with the FATCA regime. As a means of circumventing those restrictions, the US Department of Treasury has developed two model bilateral intergovernmental agreements (IGAs) (commonly known as ‘Model 1’ and ‘Model 2’),60 which the US government has either entered into or is negotiating with a number of non-US jurisdictions.61 Although the precise (p. 179) contents of an IGA must be considered in any particular case, the broad approach of these agreements is to make it easier for affected FFIs to satisfy the information reporting requirements that FATCA generally requires of them (e.g. by allowing FFIs to report the requisite information to their local tax authorities rather than directly to the IRS). IGAs may also obviate the need for withholding under the ‘passthru’ regime after it becomes effective.62 It is important to note, however, that there are still a number of jurisdictions that have not yet begun negotiating an IGA with the US.
7.60 Whilst there are certain provisions that can be drafted into credit agreements to mitigate the risk of FATCA-related withholding (e.g. requiring the facility agent to resign if it is unable to receive payments free of FATCA withholding), it is usually considered prudent for the parties to agree how the risk of that withholding should be allocated should it materialize; that is, whether the borrower should be required to gross up the withholding if it arises, or otherwise compensate the lenders for the withholding, or whether the lenders should have to receive payments under the credit agreement on a net basis. In the US loan market it is generally accepted that the latter position should prevail and that the risk of withholding should therefore fall on the lenders (at least where the withholding arises under the current FATCA regime or under any successor version of the regime that is ‘substantively comparable and not materially more onerous to comply with’63). Other loan markets, for example, in the UK and other European countries, have also generally adopted this position in recent years.
7.61 An important development in this latter regard was the LMA’s publication in 2014 of its ‘Summary Note on FATCA’,64 in which it noted that, where the facility agent operated in a Model 1 IGA jurisdiction and was not a ‘Qualified Intermediary’,65 the ‘most commonly agreed approach for investment grade transactions’ had become that contained in the third of the ‘Riders’ that the LMA previously published for dealing with FATCA withholding risk.66 Under this approach, which the LMA subsequently incorporated into its precedent documentation for English law ‘investment grade’ and ‘leveraged’ facility agreements, FATCA-related withholding on payments that the borrower makes under those facility agreements is excluded from the agreements’ gross-up and tax indemnity provisions, with the result that the lenders assume the risk of that withholding.
7.62 This particular approach of the LMA has now been adopted in a number of loan markets throughout the world. Importantly, however, the approach is premised upon the finance parties in question operating in a Model 1 IGA jurisdiction, the LMA also recognizing in (p. 180) the above 2014 Summary Note on FATCA that such an approach will not always be appropriate—for example, this may well be the case in project financings, where a finance party is located in an emerging markets jurisdiction and there is uncertainty as to whether or not the jurisdiction will enter into an IGA with the US. Indeed, in its precedent facility agreements for developing market jurisdictions, the LMA has not adopted the above approach. Instead, under these facility agreements, the position on FATCA withholding risk is left open, and the parties to the transaction must determine the extent to which that risk should be imposed on the borrower or the lenders or whether, given the fact pattern of the project in question (i.e. the location of the project, the identity of the project owners, sponsors, offtakers, agent, and lenders, and the source of revenue streams) the risk needs to be allocated at all.
7.63 In summary, therefore, the approach towards FATCA that the LMA has incorporated into its precedent investment grade and leveraged facility agreement has now been adopted in a number of loan markets throughout the world, as mentioned in paragraph 7.62. Consequently, it will usually be the lenders in a project finance transaction that assume FATCA withholding risk in terms of not being entitled to compensation from the borrower if FATCA withholding is ever due on payments to which they are entitled under that transaction.
7.64 On the other hand, one should not necessarily assume a particular allocation of FATCA withholding risk in a project finance transaction. Instead, depending upon the loan market in question, FATCA withholding risk may continue to be negotiated on a transaction-by-transaction basis, making it particularly important for parties to obtain specific tax advice in this area.
7.65 The increased costs clause that customarily features in LMA-based euro currency loan agreements67 is designed to protect lenders against changes in law (or in its interpretation, administration, or application) by virtue of which lenders or their affiliates suffer or incur additional or increased costs, reductions of amounts payable to them or reductions in the rate of return from a credit facility or on their overall capital (in each case to the extent attributable to the relevant facility). Increased costs clauses usually specifically provide that a lender will not be entitled to make claims to the extent that action or inaction on its part has resulted in the increased costs, but increased costs claims are rare in any event, in part because of the difficulty of attributing costs to a particular loan.
(p. 181) 7.66 Although, historically, increased costs clauses were designed to protect lenders against changes in law which were unforeseen at the time of signing the credit agreement (on the basis that publication of details of a regulatory change gives lenders the data that enables them to price future transactions at a level that will give them their target return), it is generally accepted that lenders should be able to make claims to recover increased costs associated with the regulatory changes68 that have followed the 2008 financial crisis, even under credit agreements signed in the knowledge that the changes were coming (at least to the extent that the relevant costs were not capable of being accurately calculated at the time of signing as a result of a lack of clarity or detail in the regulations and related guidelines). However, once these regulatory changes have been fully implemented, there will be little or no scope for lenders to request that project companies cover any costs to which such regulatory changes give rise by making claims under increased costs clauses.
Sanctions and anti-corruption
7.67 An increased focus in the market on the impact of sanctions and anti-corruption legislation on lending relationships in recent years has resulted in the provisions that relate to these matters being some of the most heavily negotiated in the credit agreement, the lenders’ focus being to ensure that the transactions into which they enter are (and, to the extent possible, will remain) compliant with all applicable sanctions and anti-corruption regimes and that the financing documentation contains mechanisms for addressing future issues in relation to such matters. Lenders now almost invariably seek specific contractual assurances from the project company with regard to, among other things, its compliance with anti-corruption and sanctions legislation. Although project companies now typically anticipate this request, and so exhibit less resistance to the inclusion of sanctions and anti-corruption protections than was perhaps historically the case, the specific drafting and scope of the protections is often still the subject of extensive negotiation.69
7.68 In addition to the direct penalties that can be incurred by financial institutions for failing to comply (either directly or indirectly) with applicable sanctions and anti-corruption laws and regulations, involvement in a transaction giving rise to a breach of sanctions or an association with a sanctioned entity or corrupt behaviour (whether or not the transaction itself is unlawful) can have serious reputational repercussions for lenders. Sanctions can also impact on credit issues—such as the ability of the project company (or an agent) to make payments to the lenders under the finance documents and the lenders’ ability to enforce guarantees or security following a breach by a project company that is a target of sanctions.
(p. 182) 7.69 There is currently no settled market position as to how sanctions and anti-corruption issues should be addressed in credit agreements.70 Although the LMA has published a guidance note71 and includes a footnote in its form of leveraged credit agreement advising lenders to consider amending the representations and undertakings to reflect sanctions laws and regulations that may affect them, its English law governed templates do not include any specific sanctions-related provisions. The absence of any real market consensus or template provisions reflects the range of approaches that have been, and continue to be, taken in the syndicated loan market.
7.70 Historically, lenders’ pre-contractual due diligence and the general assurances in the credit agreement regarding illegality and compliance with applicable laws were accepted as providing adequate protection for lenders in relation to the risk of sanctions and anti-corruption issues. Lenders that consider that this is not the case may seek to mitigate the risks by including specific representations and covenants, which may include some or all of the following:
(1) representations from the project company that it:
(a) is not the target of sanctions and does not operate in a sanctioned country;
(b) is not subject to any investigations by a sanctions authority;
(c) has not committed or engaged in any sanctionable practice;
(d) has not violated anti-corruption legislation;
(e) has conducted its business in compliance with relevant anti-corruption legislation; and
(2) undertakings from the project company:
7.71 The precise wording of such representations and undertakings will be negotiated on a transaction-specific basis and will, therefore, depend on the outcome of the lenders’ due diligence on the project company, its affiliates, and the proposed transaction (including the proposed business and the jurisdictions involved) as well as the sanctions regimes that are (or may be) applicable. Most lenders (including ECAs, DFIs, and MFIs) now have their own specific requirements as to the wording of such provisions and, in multi-sourced project financings, drafting provisions that satisfy each member of the lending group’s individual requirements can be challenging (and that is before the provisions are negotiated with the project company).
(p. 183) 7.72 In order to reflect the wide-ranging rules that apply in relation to sanctions,72 lenders will typically start with broad drafting (both in terms of the sanctions regimes covered and the persons to whom the provisions will apply). However, the complexity of current sanctions regimes, coupled with the fact that they are constantly evolving, makes it difficult (and risky) for project companies to promise ongoing compliance with such provisions. Much of the negotiation will, therefore, result from the project company’s attempts to limit the scope of the provisions so that it is comfortable that it will be able to comply with them on an ongoing basis. A project company will typically seek to limit the provisions to sanctions regimes that are ‘relevant’ for the purposes of the transaction. It may also seek to negotiate knowledge qualifiers (in much the same way as for other representations and covenants) and, perhaps most importantly, to limit the persons to whom the representations and undertakings apply.
7.73 Significant time will also usually be spent reaching agreement on the consequences that flow from breaches of sanctions representations and undertakings and, more specifically, whether they should constitute an event of default or simply a mandatory prepayment event that entitles specific lenders to exit the transaction.73 In a multi-sourced and syndicated project financing, lenders will often have differing sensitivities to breaches of sanctions-related provisions,74 with the result that it is relatively common for such breaches to constitute a mandatory prepayment event rather than an event of default. Mandatory prepayment provisions usually operate at the request of an affected lender, rather than automatically, and so effectively allow the lenders to elect to remain in the deal, an approach which is preferable from the project company perspective, particularly given the wide-ranging nature of the representations and undertakings involved. Another important consideration in the context of optional mandatory prepayment provisions relating to breaches of sanctions representations and undertakings is whether prepayments should be required to be made immediately or (recognizing the fact that the project company has limited cash resources) only from cash remaining after the project company’s other liabilities have been met.75
7.74 A lot of time is spent negotiating representations, which in project financings are extensive and in many cases repeated throughout the life of the loans.76 The purpose of the representations clause is to establish the initial set of assumptions on the basis of which the lenders are prepared to lend to the project company; if circumstances change during the availability period so that, when repeated, a representation becomes inaccurate, the lenders will be entitled to refuse to lend unless the project company satisfies whatever further (p. 184) conditions the lenders may specify in light of the new circumstances; if a representation proves to be inaccurate when made, then that fact will constitute an event of default (albeit usually subject to a materiality qualification). The representations are thus made to identify risks that are being assumed by the lenders.
7.75 The set of representations included in a credit agreement for a project financing will typically be based on those included in market standard form credit agreements such as the LMA leveraged form, with additional representations added to reflect the policy requirements of certain lenders, such as ECAs and DFIs, as well as the specific characteristics of the project company and the project. Appendix 1 sets out a checklist of some typical representations encountered in project finance transactions.
7.76 A project company will seek to restrict the scope of representations, particularly by using materiality or knowledge qualifications in respect of commercial matters, and representations of a legal nature are frequently made expressly subject to the reservations included in the relevant legal opinions. Representations will be made on the date of signing the credit agreement and selected representations will be repeated at the time of each drawdown and, in some financings, at the beginning of each interest period.
7.77 Project financing credit agreements usually include very broad covenant packages, extending beyond the project company to include the sponsors and other counterparties to material project contracts for so long as they continue to have obligations to the project. Covenant packages will necessarily differ between projects and will be influenced by a huge variety of factors, from the parties and legal regimes involved through to the markets for the applicable raw materials and production, and the capacity of the international financial markets to fund particular types of venture at a particular time (not to mention the fact that, once complete, the only source of revenue for discharging the debt and providing the sponsors with a return on their investment will be the project itself). The common theme, however, will be a tension between the conservatism of the lenders and the rather more speculative (or, perhaps more accurately, the rather less risk-averse) approach of the sponsors.
7.78 The sponsors will be confident that their project will work because they will usually have undertaken similar projects in the past with success; at the same time, they know, from experience, that they will encounter problems as the project progresses and will therefore want maximum flexibility to be able to adapt their plans (often by adopting different, and sometimes untested, ideas) as circumstances dictate. As a result, they will not want to be tied to a restrictive set of covenants that limits this flexibility.
7.79 The lenders’ perspective is quite different. They start from the position of being the participants in the project with the most to lose (because in almost every case the lenders will provide more of the capital funds for the project than the sponsors). They must then trust that the sponsors can actually do what they say they can do. (The fact that you have a contract with someone to do something does not mean that the something will be done. It means you have a remedy if it is not done, which is by no means the same thing. The lenders are, therefore, in fact placing a huge amount of faith in the sponsors.) Thus, the lenders view the covenant package as the means of protecting the investment in the project that they have entrusted to the sponsors:
(1) by ensuring that the sponsors have a basic plan to which to work;
(2) by monitoring the sponsors’ performance against that plan; and
(3) by being involved with decisions to make changes to that plan that could affect their investment.
7.80 In essence, the covenant package for a project will be a mix of undertakings to provide information, to do particular things to make sure that the project is being progressed according to plan, and not to do particular things that are likely to be damaging to the project and its prospects or detrimental to the interests of the lenders. The covenants themselves are then augmented by the requirement to meet financial ratios, as discussed in paragraphs 7.82 to 7.101.
7.81 Appendix 1 sets out a checklist of some typical covenants found in project financing credit agreements.
7.82 Project financings invariably feature financial ratios. These are designed to provide a means to enable the lenders to monitor the financial performance of the project on an ongoing basis and, from that, to predict its ability to generate sufficient revenue to service its debt obligations. At the same time, the financial ratios also provide the sponsors with a track record of performance and projected performance that they can use to demonstrate the stability of their own returns in relation to the project, which can be of particular importance to sponsors wishing to release capital (perhaps for another project) once a project is up and running.
7.83 The types of ratios and the levels used will vary depending on the project and its sensitivities, but the two most frequently encountered in limited recourse project financings are the debt to equity ratio and the debt service cover ratio (DSCR), with the DSCR often taking two forms: one which looks back over a specified reporting period—usually the 6–12 months immediately preceding the reporting date—and the other which looks forward over the corresponding period after the reporting date.
7.84 Many financings for oil and gas and other natural resource projects also include a loan life cover ratio (LLCR), although it is probably fair to say that in other financings its use has decreased in recent years.
7.85 In mining and other natural resource projects, it is also relatively common for there to be a reserve tail ratio that measures the ratio between the reserves that remain to be mined or otherwise exploited to the total reserves available at first drawdown. This is indirectly a financial ratio in that the reserve tail itself has a value, but is more a mechanism that allows long-term monitoring of the risks associated with the accuracy of the forecasting of the extent of the reserves and their depletion.
Debt to equity ratio
7.86 The debt to equity ratio features in every project finance transaction, apart from anything else because it is this ratio that reflects the relative level of the initial investment in the project of the lenders, on the one hand, and the sponsors, on the other. It is important because it is the basic measure of the level of debt that the lenders believe that the project can bear (p. 186) from a risk perspective (the greater the perceived risks, the lower the ratio because of the need for a higher equity cushion that can absorb losses attributable to unforeseen costs (or drops in revenue) associated with the increased risk).
7.87 Debt to equity ratios for projects generally range between 50 per cent (1:1) for high-risk projects such as some mining projects, to 80 per cent (4:1) for certain power station and other lower-risk projects. The ratio is seldom higher than 80 per cent, not so much because of the need for a 20 per cent equity cushion to absorb losses as because the lenders wish to ensure that the sponsors continue to have a sufficiently substantial investment in the project to ensure that, if a problem does arise, the sponsors will wish to protect their investment by working to fix the problem rather than to cut their losses and walk away.
7.88 For the purposes of the debt to equity ratio, and also for the purposes of other financial ratios that concern themselves with debt (or the cost of debt) or equity, the credit agreement and other financing documentation will define debt widely (so as to capture all manner of methods of raising finance). However, at the same time it will generally then go on to exclude debt provided by the project sponsors so long as that debt is subordinated to the debt that is owed to the lenders. The corollary of this is that, in addition to shares and other conventional ownership interests that are ordinarily classified as equity, for the purposes of these ratios, the sponsors’ subordinated debt claims will count as equity. The rationale for this (which is discussed in more detail in paragraphs 12.10 to 12.21) is that, as a rule (and depending on the jurisdiction), debt claims provide a sponsor with a greater degree of flexibility than ‘true’ equity claims.
7.89 To the extent that the applicable subordination arrangements work to ensure that, from the lenders’ perspective, the sponsors’ claims are effectively the same as the claims they would have as shareholders, there is no reason for the lenders to object to the sponsors having as much flexibility as the legal system in the relevant jurisdiction will allow.77 This is because flexibility generally means an ability to reduce costs, which in turn means both an ability to improve their own returns and also an ability to offer their customers better (and therefore more competitive) terms.
7.90 Other hybrid types of equity that are encountered relatively frequently in project financings include equity bridge loans (which are loans made to the project company under the guarantee of the sponsors on terms such that, pending repayment out of the proceeds of a subscription for shares (or a subordinated loan) by the sponsors, the lenders’ recourse in respect of the loan will be limited to their claims under the guarantee) and cash inflows to a project constituted by pre-completion net revenues, the logic for these to be counted as equity being that they arise before the time at which the sponsors’ equity commitments and/or completion support for the project falls away and should therefore be treated as earned by them rather than the project company itself.78
7.91 The LLCR and the DSCR are both ratios used to assess a project’s cashflows. The LLCR looks at the project’s anticipated cashflow through to the final maturity of the relevant loan. The DSCR tends to be divided into backward- and forward-looking elements, with the backward-looking DSCR looking at actual cashflow over the past 6–12 months and the forward-looking DSCR looking at the anticipated cashflow over the forthcoming 6–12 months.
7.92 The LLCR is conceptually very simple and compares the net present value of a project’s net revenue over the remaining life of the loan to the principal amount79 of the project’s outstanding debt. The minimum ratio is then set at a level that provides an agreed cushion against unforeseen events and changes in circumstances.
7.93 Whether or not the lenders will be able to insist (successfully) on the inclusion of an LLCR will depend on the type of project and market practice in the relevant sector at the time. Lenders will almost always require, and project sponsors will commonly accept, the inclusion of an LLCR with a cushion of 15–20 per cent in respect of power plant financings with fully contracted offtake arrangements on the basis that the relatively stable revenue streams associated with such projects (where debt to equity ratios are set at 75 to 80 per cent) means that a cushion at this level gives sufficient comfort to the lenders without being unreasonable to the sponsors. However, in mining projects (where debt to equity ratios are typically set at 50 to 60 per cent), the sponsors are likely to resist the inclusion of an LLCR on the basis that the lenders’ cushion for unforeseen adverse impacts on the project is provided by the increased headroom that is afforded by the reduced proportion of the project’s capital that is comprised of debt.
7.94 The DSCR measures a project’s capacity to meet its debt service obligations (i.e. to pay interest and principal) as they fall due. The most accurate measure of a project’s ability to meet its debt service obligations is obviously the backward-looking ratio because all the data necessary for the test is known. The advantage of combining the backward and forward tests is that by doing so, the length of the testing period is effectively doubled. This may be viewed by the sponsors as helpful, because it enables them to demonstrate that dips in short-term cashflows (which might otherwise be of concern to the lenders) are matched by prospective peaks. At the same time, the approach can be useful to lenders because it enables them to require the project company to refrain from making distributions to its shareholders after a particularly successful testing period in circumstances where the next testing period is projected to be somewhat less than successful.
7.95 It would be very unusual for a project financing not to include some variety of DSCR, but it is not particularly unusual for there to be extensive discussions as to the different components of ‘cashflow available for debt service’ for the purposes of calculating the DSCR (despite the fact that cashflow available for debt service for a period is essentially nothing more than the revenue for the period less the operating expenses for that period).
7.96 The financial model for a project, delivered as a condition precedent to the first utilization under the credit agreement, includes projected cashflows for the project prepared on the basis of agreed commercial, technical, and economic assumptions.80 The lawyers are seldom directly involved in the preparation of the model itself, but they will be involved with the preparation of the detailed descriptions and definitions that will constitute the assumptions that are used in the model (and thus its outputs and so, in turn, whether or not the project’s financial performance satisfies the requirements established by the agreed financial ratios).81
7.97 Given the complexities of any project and the fact that the assumptions in the model will inevitably prove to be inaccurate to a greater or lesser extent, the credit agreement will also include provisions that oblige the project company to prepare revised versions of the model to reflect updated assumptions and other changes in circumstances. Revised versions of the model will often need to be delivered on an annual basis at the same time as the project company delivers its budget for the forthcoming year.
7.98 The project company and the lenders are usually also given the right to deliver, or call for, an updated model, sometimes as and when they elect and sometimes only in specified circumstances, such as where there has been damage to the project or where the project has been enhanced in some way.
7.99 The credit agreement will need to regulate the arrangements with respect to updates of the model and, more importantly (because the revisions to the model may be such that a ratio can only be satisfied if a particular change is made), what happens if there is a disagreement between the parties on any of the revisions, the usual rule for the resolution of disputes in this context being an expert determination by a suitably qualified and experienced expert.
7.100 In the event of a dispute as to the revisions being made to the model, the credit agreement will provide a fall-back mechanism that specifies the assumptions to be used for the determination of the financial ratios pending the outcome of the expert determination. Ordinarily, the fall-back assumptions will be those used in the preparation of the version of the model being superseded by the revised model; where the revisions are made prior to project completion, the fall-back position is more likely to require the use of the assumptions in the original base case model (which will have been approved by all the lenders), as the dispute resolution process will involve ordinary majority lender approval arrangements.82
7.101 The financial ratios will be tested in a number of circumstances (to the extent appropriate83). These usually include:
(1) As a condition precedent to financial close (and sometimes even to individual drawdowns). The financial model (in form and substance satisfactory to the lenders) will be a condition precedent to financial close, but the lenders will also wish to see cashflow projections that demonstrate the viability of the project from their perspective and from the sponsors’ perspective. Lenders will therefore wish to see projected cashflows that demonstrate that, throughout the life of their loans, the project company is able to meet its obligations to pay principal and interest as and when due and pay its shareholders a reasonable level of distributions (to provide them with sufficient incentive to protect their investment if things go wrong). The requirement will therefore generally be that the model shows that the project will satisfy the forward-looking DSCR for each testing period through to maturity of the project loans (and, if there is one, the LLCR).
(2) As a pre-condition to achieving project completion. Completion marks the point at which (among other things) the sponsors’ completion support84 will terminate. It is therefore crucial that the project company’s prospects are then at least sufficient to meet the minimum criteria set at the time of financial close. The assumptions used for testing the financial ratios at completion will, however, be updated to reflect actual technical parameters demonstrated during the completion tests (certainly if the actual results do not meet the parameters assumed at financial close, and usually also if they surpass those parameters). The testing of the financial ratios when physical completion of the project has been achieved will either provide the parties with the assurance that everything remains on track or provide them with the opportunity to negotiate a revised test to determine completion based on a different capital structure (perhaps with more equity) or financing terms (such as a longer repayment period) that is acceptable to all parties. Either way, the lenders will wish to see forecasts that show compliance with the forward-looking DSCR for each testing period through to maturity of the project loans (and, if there is one, the LLCR).
(3) As a condition precedent to the project company making distributions to its shareholders. Whether distributions to shareholders take the form of a dividend or a payment on account of subordinated shareholder loans, the credit agreement will control distributions by reference to the project’s actual performance (by means of the backward-looking DSCR) coupled with its short-term prospects as evidenced by the forward-looking DSCR. If the particular financing package includes an LLCR, then that may also need to be satisfied before a distribution is permitted.85
(p. 190) (4) As a pre-condition to the incurrence of additional debt or replacement debt. Financial ratios may also be used to determine whether or not the project company is entitled to borrow further monies to enable it to fund the capital expenditure associated with a planned expansion of the project86 or to fund other capital expenditure that was not originally anticipated as being part of the project. Financial ratios may also be required to be met before a project company incurs new indebtedness to refinance existing debt before its maturity (for example, by issuing bonds in the capital markets after project completion to replace borrowings from ECAs or a syndicate of commercial lenders).
(5) Periodically as part of a regular compliance reporting regime in order to provide a default trigger. Credit agreements often require project companies to deliver certificates confirming their compliance with the financial ratios and other covenants to which they are subject as and when they deliver their annual or semi-annual financial statements. Although the credit agreement may provide that the mere fact that the project company is unable to meet a particular financial ratio as at a reporting date will constitute an event of default, an alternative approach, which is adopted in many instances where this is the case, is to treat the situation as a potential event of default (thereby blocking distributions to shareholders and perhaps imposing consent requirements to do things that would otherwise be permitted without consent). In these cases, the potential event of default becomes an event of default if a further compliance certificate delivered shows the ratios remain unsatisfied as at the next reporting date, but will be cured (and treated as never having arisen) upon delivery of a compliance certificate showing that the ratios are met as at the next reporting date. Credit agreements also often include provisions that entitle the lenders to call for a compliance certificate demonstrating that financial ratios continue to be met following the occurrence of events that, whilst not necessarily unforeseen, give the lenders particular cause for concern.
Events of default
7.102 As in the case of the agreements that regulate other medium- and long-term credit facilities, the events of default section in a credit agreement for a project financing identifies the circumstances in which it can be said that things have gone sufficiently wrong that the lenders should, in effect, be entitled to reassess (and ultimately terminate) the lending arrangements set out in the credit agreement.
(1) financial failure (whether simple non-payment through a lack of liquidity or complete collapse upon insolvency, and whether affecting the project company or another project participant); or
(3) the occurrence of an event which (or the extent of which) the parties did not initially contemplate.
7.104 The events of default identified in a project financing will be comparable to those in other financings, and will include with respect to the project company (and, if applicable, any guarantors):
(1) failure to make payments under the financing documents when they fall due;
(2) breach of financial covenants (i.e. a failure to meet applicable financial ratios as and when they are tested);
(3) breach of information and other undertakings (which will indirectly include breaches of undertakings in the relevant project contracts);
(5) impairment of the transaction security; and
(6) insolvency/bankruptcy and related events.
(1) misrepresentations and breaches of covenant by counterparties to material project contracts;
(2) changes in law or governmental authorizations;
(3) the insolvency/bankruptcy of counterparties to material project contracts;
(4) the revocation or non-renewal of material licences, permits, or exemptions;
(5) a shareholder’s failure to make its agreed equity contributions or to comply with its other equity support undertakings or share retention covenants;
(6) expropriation by governmental authorities; and
(7) the failure to achieve project completion or to commence operations by an agreed long stop date.
Clearly, the most controversial of these relate to defaults triggered by the conduct of persons or conditions beyond the control of both the project company and the sponsors.
7.106 Appendix 1 sets out a checklist of some typical events of default included in project financing credit agreements.
(1) oblige the project company to provide the lenders with more frequent and more detailed reports and other information in relation to the project, and to allow the lenders and their technical and other consultants greater access to the project site;
(2) trigger provisions in the financing documentation that require the lenders or their agent to approve significant items of expenditure;
(3) curtail the project company’s rights to make dividend payments and other distributions to its shareholders (and, where applicable, to make payments to mezzanine and other junior lenders); and
7.108 The occurrence of an event of default will entitle the lenders87 to exercise a number of specific rights, notably rights to:
(1) suspend or cancel their commitments to advance further funds to the project company;
(2) declare their loans to be immediately due and payable (or due and payable on demand); and
(3) take steps to enforce any and all security they may hold (whether by exercising rights of sale or by exercising so-called step-in rights whereby they (or, more likely, a special purpose company that they own, control, and finance88) step into the shoes of the project company under some or all of the various project contracts).89
7.109 As well as all the rights specifically afforded to the lenders as a result of the occurrence of an event of default (and, perhaps more important than those rights, particularly given that the rights mentioned in paragraph 7.108 are likely only to be exercised as a last resort), the occurrence of an event of default provides the lenders with the right to reassess the commercial terms of the financing in light of the default and to renegotiate those terms from a negotiating position of some (but arguably limited)90 strength. What this means in practice, therefore, is that an event of default that is of little or no consequence to the viability of the project or the lenders’ interests will be waived, more serious events of default will give rise to amendments to the finance documentation that the parties involved with the project agree are appropriate in the circumstances (whether the changes involve higher pricing, the provision of more information, stricter and fuller covenants, or further shareholder support, and everything in between), and even more serious defaults lead to Chapter 15, which deals with restructurings.
7.110 Since a true project financing is one without direct recourse to the sponsors, with cashflows from the project being the only source of debt service and repayment, the lenders will seek to impose significant, and occasionally onerous, conditions regulating the project company’s incoming cashflow and its allocation to the discharge of the project company’s liabilities.91
7.111 The lenders will generally insist on controlling virtually all the project’s cash resources until their debt is repaid and will almost invariably take security over all the project company’s bank accounts. Control for these purposes does not mean the right to approve day-to-day expenditure (or even major expenditure); rather, it means having a contractual framework that facilitates the monitoring of the project company’s expenditures (or, more accurately perhaps, a contractual framework that will highlight irregularities in actual expenditures compared with those that had been anticipated) so that irregularities can be investigated—if the investigation reveals a problem, it can be addressed at as early a stage as possible.
7.112 So long as a project has not encountered problems leading to the occurrence of events of default or potential events of default, the lenders will leave the project company to manage its own cash resources (within the parameters established by the accounts agreement). However, things will change when a default occurs. Potential events of default may trigger provisions that require lender approvals on payments (perhaps over a minimum amount) and prohibit distributions to shareholders. An event of default may trigger a complete block on payments without lender consent (or, more likely, a restriction on payments over a specified minimum unless the agent bank directs that no payments at all may be made without its consent). Ultimately, of course, if the lenders are enforcing their security, control will mean that they take whatever cash is left in the bank accounts and apply it against their outstanding loans.
7.113 In any project financing, the project company will typically open and maintain accounts both in the country where the project is located (‘onshore’ accounts) and in one of the principal international financial centres, usually London or New York (for projects in Europe, the Middle East, Africa, and the Americas), or Singapore, Hong Kong, or Tokyo (for projects in India, the Far East, and South East Asia) (‘offshore’ accounts). In a financing involving international lenders and in cases where there are concerns about political stability (or the enforceability of local security) in the host country, the lenders will usually want92 to insist that most93 of the project accounts are maintained (p. 194) offshore.94 Debt and equity proceeds, as well as project revenues (certainly if derived from offshore sales), will generally be paid into and retained in the offshore accounts, with transfers being made periodically (usually monthly) to an onshore account in an amount sufficient to meet budgeted onshore expenditure until the next scheduled transfer. Project revenues generated from onshore sales (particularly where the revenues are derived under long-term offtake contracts) are commonly paid into local accounts in the first instance and then immediately transferred to offshore accounts to the extent they exceed the amount required to pay local expenses over (say) the forthcoming month.
7.114 Whilst the exact accounts structure will differ from project to project, one of the main control mechanisms used by lenders is the payment ‘waterfall’ or ‘cascade’. A payment waterfall itself is simply a list of different classes of liabilities that the project company must discharge. The accounts agreement then provides that all monies received by the project company must be paid into one or more designated receipt or revenue accounts, and from there to accounts from which amounts may only be paid for specified purposes and otherwise in accordance with the finance documents. The transfers are made at designated times and on the basis that funds are only transferred to accounts that appear ‘lower’ in the waterfall to the extent that (to continue the metaphor) they trickle down as a result of an overflow of funds higher up. The ‘overflow’ from each account is determined by reference to agreed levels of the future payments from that account that must be assured before funds are released. Thus, incoming cash will be credited to (say) the operating account until the balance on the account is sufficient to pay the next month’s projected operating and maintenance expenses of the project; once this is the case, funds might spill into an income tax accruals account until payments into that account made in a given month total one-twelfth of the budgeted tax bill for the year, and so on. The waterfall will thus take account of the timing mismatch between cash inflows and cash outflows. (In fact, most accounts agreements will include separate waterfalls for a project’s construction and operating phases.95 These are considered separately in paragraphs 7.117 and 7.118, respectively.)
7.115 The basic rule for the waterfall is that operating expenses and project costs will be paid before debt service96 and debt service is paid before distributions to shareholders. Things then get more complicated (and controversial) depending on the project. There may be a requirement to build up a major maintenance or decommissioning reserve (so that when the maintenance or decommissioning occurs, the project company has funds in hand to meet the resulting costs), but should credits be made to these accounts before debt service payments are made? The lenders will want to say no, but the project company (and perhaps the host government whose interest is to see the project site cleaned up after decommissioning) (p. 195) will say yes. Similarly, it is normal to have funds credited to a debt service reserve account (covering an agreed number of months’ debt service costs so that if there is a drop in revenue (resulting in less cash flowing down through the waterfall and into the account from which debt service payments are made) the project company will still have sufficient funds available to meet its debt service obligations); but should this reserve be fully established before (say) prepayments are made to a lender affected by illegality? The more common approach is to permit prepayments only if the debt service reserve account is fully funded (but there is no right or wrong answer on the point and some agreements provide otherwise). Obligations to make payments arising on termination of hedging agreements will (except where they arise after acceleration of the project loans, when they will be treated in the same way as the principal of the loans) be treated as obligations to prepay principal and so tend to rank after scheduled repayments of principal (and usually after reserve accounts have been fully funded).
7.116 The payment waterfall and other account operating mechanics, as well as provisions governing the relationship between the account bank, the other finance parties, and the project company, will be detailed in the common terms agreement or in a stand-alone accounts agreement. The latter is likely to be more appropriate where the account bank is not also lending to the project and prefers not to be party to the common terms agreement (or, with respect to onshore accounts (as to which see paragraph 7.113), where the account bank insists that the governing law applicable to the accounts agreement should be the same as that applicable to the relevant accounts).
Construction phase waterfall:
7.117 Debt and equity proceeds will usually be deposited into a single designated receipt or revenue account from which funds are then withdrawn periodically to pay project costs, including debt service costs, as they fall due. Construction phase waterfalls are relatively simple, with costs payable to third parties having priority over debt service costs (because the bulk of the incoming funds to meet the outgoing payments actually come from the debt being provided by the lenders). One issue linked to the construction phase waterfall that sometimes engenders discussion is the application of pre-completion revenues (e.g. where one of a number of production units has become fully operational (and is thus generating revenue) but completion is defined by reference to all of them having become operational). Where the amounts generated are significant, the lenders often insist that these funds are applied in prepaying outstanding advances (or in paying project costs that would otherwise have been paid with the proceeds of advances and cancelling undrawn credit lines accordingly) or funding debt service reserves. However, it is not uncommon for lenders and sponsors to agree to share pre-completion revenues by crediting them to a special revenue account that is available to pay project costs, and, at completion, transferring the balance on the account to the project’s ordinary revenue account (so that it flows down the waterfall first to fund all applicable reserve accounts and then to fund distributions to shareholders).
Operating phase waterfall:
7.118 After project completion, as mentioned previously, the typical waterfall will provide for the payment of operating costs before debt service and for debt service to be paid before shareholder distributions. The logic for paying operating costs first is simply that these payments need to be made to ensure that the project continues to operate: if a power station’s fuel supplier is not paid for the fuel he has supplied, he will not make further fuel deliveries and the power station will cease to generate (resulting in (p. 196) a loss of revenue and, possibly, claims for a failure to provide power); if the employees at a mine are not paid, they will seek alternative employment elsewhere (resulting in a loss of production). Whilst it is bad news if the lenders are not paid, a debt payment default does not of itself impact the ability of the project to continue to operate and produce revenue. A simplified operating phase waterfall is likely to establish the following priorities for payments:
(1) operating costs and taxes;
(2) lenders’ agents’ fees, costs, and expenses;
(3) interest payments (and scheduled payments under interest rate hedges);
(4) scheduled repayments of principal;
(9) voluntary prepayments and prepayments of individual lenders that have made claims under indemnities for taxes and increased costs or are receiving payments that are required to be grossed-up as a result of withholding taxes;
(11) distributions to the shareholders (if all distribution conditions are met, as to which see paragraph 7.119).
Use of excess funds
Distribution and dividend restrictions:
7.119 The accounts agreement will operate in parallel with the other provisions of the financing documentation97 that restrict the project company’s ability to make dividend payments and other distributions to its shareholders so that no distributions may be made unless (for example):
(1) the sponsors have made their equity contribution in full;
(2) there are no continuing actual or potential events of defaults; and
(3) specified financial ratios were met at the most recent testing date.
7.120 Although from the perspective of the account bank large cash balances on the project accounts is a good thing, the project company, its shareholders, and the lenders will generally take a contrary view because the return on these accounts will usually be lower than the return that can be achieved from other investments (even if those investments are themselves classified as low risk and so carry relatively low returns). It is common, therefore, for the project company to be entitled to withdraw cash that will be sitting in the project accounts for any length of time to make so-called permitted investments.98
Cash substitution and acceptable credit support:
(p. 197) 7.121 A more attractive proposition to the sponsors than the project company’s entitlement to use funds in the project accounts to make permitted investments is for the sponsors to be given the use of the funds in return for an undertaking to put them back should they be needed by the project company. Whilst some sponsors may have credit ratings such that lenders are comfortable with nothing more than the sponsor’s own undertaking to replenish funds that they have borrowed in this way, it is much more likely that the lenders will only permit withdrawals if the relevant cash balances are substituted by standby letters of credit (or on-demand guarantees)99 issued by international banks with a minimum credit rating. The terms of the financing documents that regulate these cash substitution arrangements will generally stipulate that the relevant issuing bank may have no recourse to the project company in respect of amounts that may be demanded of it under the relevant instrument. It will thus be for the issuing bank to enter into suitable reimbursement agreements with each sponsor to ensure that it is indemnified for payments that it may make and which are attributable to that sponsor.100
The account bank
7.122 The accounts agreement is also useful for disapplying certain rights that the account bank enjoys, whether under the normal banker–customer relationship or pursuant to its particular bank mandate. Lord Denning MR’s statement in Halesowen Presswork & Assemblies Ltd v Westminster Bank Ltd describing the banker’s right to combine accounts makes it clear why express provisions in the accounts agreement are desirable to counteract the effects of this right:
… in the ordinary way, when a customer has one account with the bank which is in credit, and another which is in debit, the banker has a ‘lien’ on the credit in the one account which entitles him to apply that credit in discharge of indebtedness on the other account.
Seeing that the banker’s lien is no true lien, in order to avoid confusion, I think we should discard the use of the word ‘lien’ in this context and speak simply of a banker’s right to combine accounts; or a right to ‘set-off’ one account against the other.
Using this phraseology, the question in this case is: suppose a customer has one account in credit and another in debit. Has the banker a right to combine the two accounts so that he can set-off the debt against the credit, and be liable only for the balance? The answer to this question is: yes, the banker has a right to combine the two accounts whenever he pleases, and to set-off one against the other, unless he has made some agreement, express or implied, to keep them separate.101
(1) any rights of set-off with respect to monies credited to any project account;
(3) any other rights over (or to monies credited to or investments made using funds in) any project account.
Such undertakings curtail the rights that the account bank would customarily have under the normal banker–customer relationship (in England at least) to appropriate monies credited to the project company’s accounts and (notwithstanding the lenders’ security interest) set them off against liabilities owed to it by the project company.
Acknowledgment of security:
7.124 When the lenders take security over a project company’s bank account and the monies credited to it, they are taking security over the project company’s contractual claim to those monies. In order to ‘perfect’ their security interest, the project company must generally give the bank with whom the account is maintained notice of the lenders’ interest. The accounts agreement provides a convenient means whereby the project company and/or the lenders provide notice of the security interest to the account bank (coupled with appropriate directions as to the operation of the particular account—so that, for example, monies in a debt service reserve account may only be withdrawn if the lenders’ agent approves the withdrawal, whilst monies in an operating account may be withdrawn at the direction of the project company unless the agent has directed otherwise102) and the account bank acknowledges receiving notice of the security interest and the related directions.
No other accounts:
7.125 The project company usually covenants that it will not establish any accounts other than those prescribed in the accounts agreement unless the new accounts are regulated by the accounts agreement (which can be achieved if the new accounts are opened with the existing account bank or if there is a mechanism for a new account bank to accede to the accounts agreement) and are secured to the same extent as the existing project accounts.
7.126 As discussed in paragraph 7.112, the accounts agreement will usually leave the project company free to deal with its cash resources until the occurrence of a potential event of default (or an event of default), at which point the lenders will be entitled to exercise whatever levels of control are agreed with respect to the particular account, whether that be a complete lock-up prohibiting any payments without consent or something less restrictive than that.
Access to books and records; confidentiality:
7.127 To enable the finance parties to monitor the project accounts properly (which, as discussed in paragraph 7.111, is the basic premise behind the accounts agreement), the accounts agreement will include provisions pursuant to which the project company specifically authorizes the account bank to give the lenders’ agent (and perhaps other finance parties and certain consultants) access to its books and records with respect to the project accounts that the project company maintains with the (p. 199) account bank, thereby ensuring that by making any such information available to the finance parties the account bank is not acting in breach of any general duty of confidentiality that it may owe to the project company.
Mezzanine Facility Agreements
7.128 Although mezzanine finance is a common component of the capital structures seen in the world of leveraged acquisition financings, it seldom features in project financings. Whilst unusual, however, particularly in markets outside the US, mezzanine debt can prove to be helpful as a means of bridging funding gaps in financing plans, particularly in circumstances where there is a general lack of market liquidity or limited market interest in providing financing in a particular sector.
7.129 Mezzanine debt is simply an intermediate layer of debt which is subordinate103 to the project company’s ‘senior’ debt but which is senior to the project company’s ‘junior’ (i.e. normal subordinated) debt. One of the key benefits to sponsors in using mezzanine finance is that, where necessary, it enables them to offer a relatively small group of lenders a variety of equity linked and other incentives to encourage them to accept the greater risk associated with their subordinated status instead of having to pay them interest at prohibitively high rates. Interest rates on mezzanine loans will be higher than those on senior loans (and often significantly so) because of the incremental credit risk that the mezzanine lenders are assuming. Without other incentives, however, the interest rates needed to attract the lenders might need to be raised to a level where they become unattractive to the sponsors—paying higher rates of interest will necessarily reduce the sponsors’ returns because the interest must be paid irrespective of the level of a project’s future performance. Agreeing to share potential upside in the equity value of a project will only represent a cost to the sponsors if there is an upside to share.
7.130 Mezzanine facility agreements often feature ‘payment in kind’ (PIK) provisions whereby only part of the interest on the loans is required to be paid in cash, the balance being capitalized, either automatically throughout the life of the loan or as and when the project company elects. PIK provisions with ‘toggle’ options (which simply means that the project company can elect whether or not interest is capitalized when it falls due) are attractive to project companies because they are in effect credit lines that allow the project company to borrow funds to pay interest and so free up cash for other purposes.
7.131 Mezzanine investors generally seek to augment rather than replace the sources of traditional senior funding for projects and thus tend to be specialist lenders who are able and willing to provide debt that is, for whatever reason, unattractive to conventional senior lenders. However, in recent years a number of ECAs, DFIs, and other financial institutions, such (p. 200) as the European Investment Bank, have participated in both senior and mezzanine or other subordinated debt tranches, particularly in the mining and telecoms sectors, thereby spreading pricing and risk across facilities.
7.132 The mezzanine facility for a project will usually be documented on substantially the same terms as the senior facility. One of the main areas of negotiation for a project financing involving a mezzanine facility, beyond the interest rate provisions and cover ratios (which will be less stringent than those applicable to the senior facility so that they will only be breached if there is a major problem),104 will be the intercreditor arrangements regulating the relationship between the mezzanine lenders and the senior lenders. Some of the key tension areas are outlined here.
7.133 In contrast to the leveraged buy-out market, where mezzanine lenders will customarily have a more active role in decisions that require senior lender consent, in project financings the mezzanine lenders will often have no, or very limited, voting or consent rights with respect to decisions—and usually only in relation to matters that directly affect their debt. Thus, while the financing documentation will entrench key provisions such as the cashflow waterfall, most day-to-day decisions that require the consent of the senior lenders will not require consent from the mezzanine lenders.105
Cashflow waterfall priority:
7.134 Where a project financing includes mezzanine debt, the operating phase waterfall106 (and the waterfall that regulates the application of the proceeds of the enforcement of any security that secures both senior and mezzanine liabilities) will provide that no payments (of principal, interest, or otherwise) may be made in respect of the mezzanine debt unless all amounts then due and payable under the senior facility107 have been paid in full. Moreover, the intercreditor agreement will also include payment-blocking provisions that allow the senior lenders to issue ‘payment stop’ notices that prohibit the project company paying any mezzanine liabilities following the occurrence of a senior event of default (or sometimes only certain material events of default, which would include a breach of any financial ratio)108 and ‘standstill’ provisions that prohibit (p. 201) mezzanine lenders from taking steps to enforce their contractual rights as a result of not being paid (or other defaults) for a specified ‘standstill’ period (which is usually 180 days but can be longer).
Amendments and waivers:
7.135 As mentioned in paragraph 7.133, most day-to-day consents required of the senior lenders under the senior credit facility do not require consent from the mezzanine lenders. The senior lenders will also want to retain as much control as possible in relation to amendments and waivers that may be required when things go wrong and events of default have occurred in order to minimize the opportunities for the mezzanine lenders to use the amendment or waiver process as a means of negotiating better terms for themselves at a point when the risk that they have accepted (essentially insufficient revenue to meet the project’s liabilities) actually materializes. The idea behind the payment blockage and standstill arrangements mentioned in paragraph 7.134 is to provide a window (i.e. the ‘standstill’ period) during which (i) the project’s cash will be conserved (because the payment blockage means that it will not be applied to service mezzanine debt liabilities) and (ii) the lenders, the project company, and the project sponsors have the opportunity to negotiate revisions to the financing terms applicable to the senior debt without interference from the mezzanine lenders so long as they do not change entrenched provisions that are designed to protect the mezzanine lenders.
7.136 The intercreditor regime between senior and mezzanine lenders that operates in relation to amendments and waivers (outlined in paragraph 7.135) is intended to cater for cases where things have gone wrong (meaning that, with a degree of restructuring, the project should be able to generate sufficient revenues to service all its debt and still give its shareholders a return, albeit a smaller one than previously envisaged), but not so horribly wrong that the lenders elect to enforce their security rights (meaning that it is likely that not all the senior and mezzanine debt can be repaid, which in turn means that the mezzanine lenders will lose some or all of their investment). However, the intercreditor rules that apply in both cases are similar—the basic rule being that the senior lenders should control the enforcement process subject to some basic protections for the mezzanine lenders. The enforcement mechanics will typically be set out in the intercreditor agreement and are discussed in more detail later.109
Equity Bridge Facility Agreements
7.137 The equity bridge loan (or EBL) is a means by which sponsors improve the return that they make on their equity investment in a project by deferring the date on which they make it for as long as possible. They are now widely used in the water and power sectors, particularly in projects benefiting from creditworthy long-term offtake contracts such as are to be found in the Middle East. They are also increasingly being used in refinery, petrochemical, and other process industry projects.
7.138 An EBL is a loan made to the project company for financing project costs that would otherwise be financed by the proceeds of equity capital or subordinated shareholder loans. (p. 202) The loan is made by a bank but is guaranteed by the relevant sponsor and is repayable (whether at or before maturity, which will be at or within a year (or even two) following completion) from the proceeds of new equity which is subscribed (or a shareholder loan which is made) by the relevant sponsor. Specifically, the EBL is not part of the limited recourse project financing arrangements. As such, the project lenders will wish to ensure that the principal of the EBL110 is not repayable out of project cashflow (except to the extent that the project cashflow could have been paid to the project company’s shareholders). The effect of the EBL is therefore to allow more of a project’s costs to be financed initially with debt rather than equity and subordinated shareholder loans.111
7.139 The preference of the project lenders will be that any EBL facilities are drawn before the senior project loan facilities (at least to the extent this is practicable),112 and the fact that EBLs carry lower interest margins (because rather than project risk the lenders are taking the sponsors’ credit risk through their guarantees or other credit support) means that sponsors will have a natural inclination to agree to this approach. The project lenders have a legitimate reason for requiring the disbursement of the EBLs before the disbursement of the project loans: if there is a problem with a sponsor’s credit status, the EBL lender will stop increasing its exposure and so will not allow further drawings of the EBL facility. A comparable risk exists where the sponsors commit to fund their equity contributions pro rata with drawings under the project facilities, but in that case a problem with a sponsor’s credit status is likely to be dealt with by way of a right to make a call under a guarantee or letter of credit supporting the sponsor’s commitment. If an EBL facility is to be drawn pro rata with the project loan, the important thing for the project lenders to ensure is that, should the EBL lenders not make an advance under the EBL facility for any reason (and, in particular, notwithstanding that they may have no obligation to do so as a result of the occurrence of an event of default under the EBL facility agreement), the relevant sponsor is under an obligation (supported, if appropriate, by a suitable guarantee or letter of credit) to make the missing funds available to the project as if there had been no EBL facility.
7.140 If the EBL lenders have any claims against the project company at all, then the senior project lenders will want them to confirm that those claims are fully subordinated to the claims of the senior project lenders, which is usually achieved by having the EBL lenders as parties to the intercreditor agreement. EBL lenders are sometimes secured,113 but even where this is the case, their claims on any proceeds derived from the security will rank (p. 203) after the claims of any mezzanine lenders and they will have no say when it comes to decisions with respect to the enforcement of the security.
EBL debt service:
7.141 As mentioned in paragraph 7.138, one of the features of an EBL loan is that the principal of the loan is not repayable out of project cashflow (except to the extent that the project cashflow could have been paid to the project company’s shareholders). However, current interest payments on the EBLs are usually payable under the waterfall (often up to a capped amount) unless a default occurs; in that case, the EBL lenders would need to make a claim on the sponsor’s guarantee for the relevant interest payment. The subordination provisions in the intercreditor agreement would then operate to prohibit the project company reimbursing the sponsor for the payment it has made except out of funds that would otherwise have been available to shareholders.
7.142 Given the subordination arrangements in relation to the EBL, there is no reason why the occurrence of an event of default under the EBL should, of itself, automatically be an event of default under the project loans, so the cross-default provision in the credit agreement should not be triggered by the occurrence of an event of default (or potential event of default) under the EBL facility agreement. It may, however, be appropriate for a particular set of circumstances (such as the insolvency of the relevant sponsor) to be an event of default for the purposes of both agreements, but whether this is the case will depend on whether the sponsor has continuing obligations to the project company as well as obligations to the EBL lenders.
7.143 A syndicated credit agreement is a form of intercreditor agreement. It includes provisions that require the exercise of many of the lenders’ rights thereunder on a collective basis (and only on a collective basis), with the result in most instances that decisions of the lenders to exercise, enforce, waive, or amend their rights may only be taken if a majority of the lenders (or sometimes all the lenders) agree. It includes waterfall provisions that provide for the pro rata distribution of payments among all the lenders and provisions that require a lender that, for any reason, receives more than its pro rata share of amounts owed by the project company thereunder to share the excess so that, ultimately, losses are shared by the lenders in their agreed proportions.
7.144 The documentation for a project financing will not necessarily include a stand-alone intercreditor agreement—a project with a straightforward financing plan may adopt a basic voting and sharing structure adapted from a syndicated agreement in the common terms agreement. However, the increasing complexity of the financing arrangements for projects and the differences in the approaches to the financings adopted by (or the rights of) the project’s funding sources mean that, as a general rule, there will be a separate intercreditor agreement for the financing.
7.145 The intercreditor agreement relating to even the most complex financing plan is ultimately just a development of the voting and sharing provisions in an ordinary credit agreement, but with the voting provisions, for example, taking into account the fact that bondholders (p. 204) are not best placed to be involved in votes on decisions relating to many of the issues that are of great interest to ECAs, and the waterfall and sharing provisions taking into account that the claims of mezzanine lenders need to be subordinated to the claims of the senior project lenders. However, it is misleading (and overly simplistic) to regard the intercreditor agreement as nothing more than a voting and sharing agreement. It is better to regard it as an agreement that restricts the rights that each creditor has in relation to its claims against the project company and the project both in terms of the exercise of those rights (and the security for them) and in terms of their amendment.
7.146 The parties to an intercreditor agreement will include senior lending groups (perhaps including bondholder groups), hedge providers, mezzanine lenders, and subordinated lenders (present and future), and may or may not include the project company (as to which see paragraph 7.155). They may also include key long-term suppliers and offtakers, particularly where the supplier or offtaker is a sponsor (or an affiliate of a sponsor): a feedstock supplier for a petrochemical plant may, for example, accept payment for a proportion of the feedstock that it supplies to the project on deferred terms, while an offtaker may make advance payments for the products it has agreed to buy from the project. The liabilities associated with these arrangements can represent significant sources of funding for a project, and the rights of the relevant counterparty to enforce its claims and to vote are matters that should be regulated by the intercreditor agreement, as are issues such as whether the counterparties should benefit from the senior security package, whether their claims should be pari passu with (or below, or even above) the claims of the senior creditors in the operating cashflow waterfall (perhaps up to an agreed limit), and whether the counterparties should waive set-off, retention, and other rights that suppliers and offtakers include in their contracts as a matter of course.
Priorities and subordination
7.147 One of the key purposes of any intercreditor agreement is to regulate the priorities of the claims of the project’s long-term creditors (all of which would, ordinarily, rank equally (or ‘pari passu’) as a matter of law. More specifically, the intercreditor agreement will subordinate (a) the claims of any mezzanine lenders to the project to the claims of the project’s senior lenders, and (b) any claims that the project company’s shareholders may have as lenders as a result of making loans to the project company rather than subscribing for shares in the project company114 to the claims of both the senior lenders and any mezzanine lenders.
7.148 The effectiveness of subordination provisions in an intercreditor agreement insofar as they concern the application of cashflows using a priority of payments waterfall such as discussed in paragraph 7.118 is a straightforward matter of the law of the jurisdiction that governs the intercreditor agreement. So, too, is the effectiveness of the provisions in the intercreditor agreement that regulate the application, as between secured creditors, of the proceeds of any security for their claims. If the intercreditor agreement is governed by English law, in neither of these cases is there an issue as to the efficacy of the subordination of the claims of creditors lower down the waterfall: to the extent that there is insufficient cash to pay the subordinated claims, then those claims remain unpaid. That is the (p. 205) arrangement to which the subordinated creditors have agreed in their contract and that is the arrangement to which the English courts will give effect.
7.149 Complications arise, however, where the subordination provisions in an intercreditor agreement are intended to operate in circumstances where the project company is insolvent, because when a company or other entity is classified as insolvent under applicable law (which is essentially when it lacks the resources to discharge its liabilities) the law imposes rules designed to ensure that all the creditors of the company or other entity generally are dealt with on the basis of a level playing field. The complications are compounded by the fact that, irrespective of the governing law of the financing and other transaction documentation for the project, the law applicable to the project company’s insolvency will generally be the law of the jurisdiction in which it is incorporated or otherwise established, which is most likely to be the jurisdiction in which the project is located (or possibly a tax-friendly jurisdiction such as the Cayman Islands or Bermuda).
7.150 In one way or another, and at the most basic level, the insolvency rules in most jurisdictions provide that if a company or other entity is found to be insolvent and incapable of being restored to financial health, the company and its assets are subjected to some form of formal liquidation process pursuant to which its assets are sold and the proceeds of sale are distributed among the company’s unsecured creditors in proportion to their claims against the company. This is the essence of the so-called pari passu principle.
7.151 The insolvency rules will respect third-party security interests in the company’s assets (subject to safeguards designed to avoid abuse) and are likely to include special preferment arrangements for certain creditors such as employees, but the basic objective is to treat the company’s unsecured creditors fairly. One of the consequences of the rules on the distribution of monies in a liquidation being imposed by law (i.e. the applicable insolvency rules) is that a contractual arrangement between a debtor and its creditors which purports to provide for a distribution other than the one prescribed by law will not be effective. This is the reason behind the concern that, under English law, contractual subordination provisions might be susceptible to being set aside on the grounds of public policy under the rule in British Eagle v Air France.115 Although it is now generally accepted that, as a matter of English law,116 contractual subordination provisions should not be set aside on this basis where the contract does not seek to provide for the relevant creditor to enjoy some advantage in an insolvency which is denied to other unsecured creditors, the position may be different in other jurisdictions.
7.152 Irrespective of the jurisdiction the laws of which will apply to the project company’s insolvency, the simplest way to bypass issues in relation to the effectiveness of the subordination provisions in the intercreditor agreement is to require that the subordinated creditors’ claims against the project company are assigned to the security agent on behalf of the senior project lenders as part of their security package in the same way that their shares in (p. 206) the project company are charged as security. By adopting this approach, the security trustee will be the person entitled to prove in the project company’s insolvency for, and receive amounts distributed in respect of, the assigned claims. In the (rather unlikely) event that the amounts so distributed exceed the unsecured claims of the senior project lenders, the excess can be returned to the subordinated creditor.
7.153 In any event (and again irrespective of the law that will apply in the case of the project company’s insolvency), subordination provisions in intercreditor agreements are almost invariably bolstered by provisions that:
(1) prohibit the subordinated creditor from submitting a proof in the project company’s liquidation in respect of its subordinated claim unless directed to do so by the senior creditors; and
(2) require the subordinated creditor to ‘turn-over’ any amount it receives in respect of its subordinated claims (irrespective of the reason for the receipt) to the security agent for distribution among the creditors under the intercreditor agreement as if the amount had been realized through the enforcement of security (and pending discharging its ‘turn-over’ obligation, hold the amount to be turned over on trust for the senior project creditors or the security agent),
and will often also include provisions which entitle the security agent to release the subordinated creditors’ claims against the project company (including claims that arise by subrogation) in connection with the enforcement of security.
Drafting and negotiation considerations
7.154 The LMA’s standard form of intercreditor agreement is not necessarily the best starting point when there is a need to produce an intercreditor agreement for a project financing. It is not a bad starting point (and is particularly useful when it comes to identifying a number of aspects of the relationships between creditors that should perhaps be considered in any transaction), but because it was designed to address issues arising in a classic European leveraged acquisition financing with mezzanine debt in the capital structure, it is likely to be unnecessarily complicated in some respects and to lack any guidance at all in relation to a number of matters that are of particular importance in a multi-sourced project financing transaction.117 It is likely, therefore, that in many instances the intercreditor agreement will be based on recent (and relevant) market precedent documentation rather than on the LMA form.
7.155 Even in cases where it is agreed that the project company should not be a party to the intercreditor agreement (on the basis that intercreditor matters are just that—matters (p. 207) between creditors—and so should be dealt with in an agreement between creditors alone), the project company will be closely involved with the negotiation and finalization of the terms of the intercreditor agreement prior to financial close. Thereafter, and to a greater or lesser extent depending on the particular terms, the project company will need to provide its consent to amendments to the agreement so that agreed voting thresholds and other key terms (and definitions) are preserved. However, that is not to say that the sponsors should produce the first draft of the intercreditor agreement for a transaction (even where they produce the first drafts of the other principal financing documents and even where the project company is a party). That may make sense if the parties are familiar with the particular precedent that is to be used as the base document for the intercreditor agreement, but in most instances the fact that it is the creditors’ rights that are constrained by the intercreditor agreement means that it is more appropriate for the creditors (and specifically the senior project lenders) to have this responsibility.
7.156 The intercreditor agreement is not usually finalized until the full complement of finance documents for the transaction has been largely settled, because only then is it clear what it must address. Key intercreditor features (such as the voting thresholds required to approve amendments and waivers relating to particular covenants or agreements, to approve the giving of acceleration notices and to give directions with respect to the enforcement of security) should be agreed as part of the term sheet discussions and embodied in agreed ‘intercreditor principles’ in order to avoid problems towards the end of the process of documenting the transaction. It is important to have the main commercial terms of any transaction settled early, but this is particularly so in relation to intercreditor terms because some of the issues that they raise are sufficiently fundamental to be ‘deal breakers’, not just for a particular participant in the financing, but also for a whole class of lenders contemplated by the financing plan.118
7.157 Given the inherent conflicts of interest between different classes of creditor (and often between different creditor groups within the same class, such as where a financing includes a bond issue or a mezzanine facility), it is not uncommon for individual creditors and classes of creditors to retain separate counsel (or sometimes, and subject to applicable professional conduct rules where a firm’s clients have a conflict of interest,119 a separate legal team at the firm appointed to act as common lenders’ counsel) to advise them on intercreditor matters.
7.158 The more complex a project’s finance plan, the more complex its intercreditor agreement will be. This section discusses some of the key issues that may be encountered in relation to a moderately complex intercreditor agreement. Much of the complexity with respect to (p. 208) intercreditor agreements comes from the simple fact that different groups or classes of creditor have different perspectives on different issues, leading to a need for different compromises to suit different circumstances. Something that works as between the project company and one syndicate of commercial banks on one transaction may need adjustment so that it is acceptable to another in a different transaction; something that is agreed between the senior creditors and the mezzanine lenders may need to be modified to avoid creating an issue for the sponsors; something that works as between the mezzanine lenders and the sponsors may need to be amended before it becomes acceptable to the senior lenders; something that works for the senior lenders and the sponsors may cause the mezzanine lenders a problem which will need to be solved; transactions with rated debt tranches will need to take account of matters that are of particular concern to rating agencies (who may have concerns with compromises agreed between all the parties to the transaction and who may therefore require that those compromises be changed).
7.159 One of the results of this complexity (and the multiplicity of the compromises that it produces) is that market practice in relation to intercreditor agreements taken as a whole is far more difficult to discern than it is in relation to credit agreements (even the most complicated of which is essentially bilateral in nature, with the project company (and its shareholders) on one side of most debates and the lenders on the other). The point here is that there is a need for considerable flexibility between the parties on the points that arise in relation to an intercreditor agreement because it is seldom the case that the compromise agreed on one transaction will work on the next. It might, but other factors and other parties with different interests are more likely to mean that the later transaction will need its own solutions.
7.160 The upshot of what is said in paragraph 7.159 is that there is no template for the intercreditor agreement for a project financing. However, there are a number of issues which the intercreditor agreement for a project should address. Broadly speaking, apart from matters to do with the creditors’ relative priorities, these comprise:
(1) the actions that different creditors may or may not take in relation to the agreements to which they are parties, both in terms of the exercise of their rights thereunder (and the security for those rights) and in terms of the amendment to the terms thereof;
(2) the voting rights enjoyed by the various creditor classes and the voting thresholds that apply in different circumstances;
(3) the circumstances in which the security agent is entitled to release the claims of junior creditors against the project company (as mentioned in paragraph 7.153); and
(4) junior creditor protective provisions (such as those discussed in paragraphs 7.170 to 7.172).
Restrictions on creditors’ rights
7.161 The intercreditor agreement is designed to ensure that decisions that affect (or may affect) the creditors are taken in an orderly fashion and on the basis of an agreed set of rules against a backdrop of an agreed set of contractual arrangements. Decisions need to be taken with respect to a project financing transaction for all manner of reasons, from the relatively mundane decisions in relation to waivers and consents in relation to restrictive covenants and immaterial defaults, through to decisions with respect to the restructuring of the project debt (or even its acceleration and the enforcement of security).
(p. 209) 7.162 Whilst the decisions are questions of how the creditors exercise their rights under the financing documentation in relation to the project, from the perspective of the individual creditor (or group of creditors) the essence of the intercreditor agreement is that it operates (a) (through restrictive covenants) to restrict the exercise by that creditor of some of its rights under the financing documentation (such as the right to accelerate its debt claims following the occurrence of an event of default under its credit agreement with the project company and its right to amend the terms of its credit agreement), and (b) (through majority voting arrangements) to negate the effect of the exercise of some of its other rights under the financing documentation (such as the right to withhold its consent to the project company’s request to do something prohibited by its credit agreement: the withholding of consent by a particular creditor is without effect if the requisite majority approve the relevant action).
7.163 The rights of more junior creditors (as a class) will generally be more restricted than the rights of more senior creditors (as a class). Thus, mezzanine creditors may be restricted from exercising their rights to accelerate their debt for a ‘standstill’ period120 in circumstances where no such restriction applies to the senior creditors (the theory being that this provides the senior lenders with time to decide how best to proceed).
Voting rights and structures
7.164 By and large, even where a financing includes mezzanine debt, it will be the senior creditors that control most decisions, although decisions on amendments to the finance documents that impact junior creditors (such as changes to the waterfalls, increases in the senior project debt or interest thereon, and alterations to the rate at which the senior debt amortizes) are likely to require the approval of mezzanine and other third-party121 subordinated creditors (as classes) as well. The intercreditor agreement will, however, generally authorize the senior creditors alone to take decisions with respect to the release of security covering both senior and mezzanine debt in order to provide them maximum flexibility should a debt restructuring become necessary, even though the release may be prejudicial to the interests of the mezzanine lenders.122
7.165 The most common voting framework for a project financing transaction simply links different decisions or categories of decision to different voting requirements, generally based on one vote for each dollar of debt123 and usually counting undrawn commitments before project completion except in relation to decisions to accelerate or enforce security (on the basis that in these circumstances the undrawn commitments will never be drawn). Votes may be counted on an individual creditor basis or on a ‘block voting’ basis. Block voting works on the basis of the different syndicates involved in the financing taking independent votes on a matter (on the basis of whatever majority requirements are specified in their own (p. 210) credit agreement) and, for the purposes of the intercreditor agreement, treating a majority positive (or negative) vote of the syndicate as a unanimous vote.
7.166 The key drivers for determining the structure of the voting arrangement for a particular financing will be precedent transactions in the relevant sector and jurisdiction, and the identity and character of the creditor group. Whilst this makes it sound simple, the voting arrangements are often one of the most complex aspects of a project finance intercreditor agreement, primarily because of the variety of the funding sources involved and the different ways in which they interact in different jurisdictions (which makes for a huge range of permutations).124 Further complexity comes from the fact that the different funding sources have different (and sometimes very different) maturity profiles, which may make it appropriate to adjust the voting arrangements over time to maintain the initial ‘balance of power’ (or something reasonably close to it), or perhaps simply to ensure that no particular creditor or group of creditors (whether or not officially a class) is able to wield an undue level of influence on decisions. Similar issues arise where creditors provide loans in different currencies: should votes be calculated by reference to historic exchange rates (so that everyone knows where they stand) or should they be calculated on the basis of current rates (which appears to be fair, but in most instances is probably the wrong thing to do because it is an arbitrary approach that can produce unexpected results)?
7.167 Whilst decisions classified as administrative, mechanical, or routine are often delegated to the intercreditor agent or the security agent (albeit on the basis that the agent will always be entitled to take the ‘do nothing’ option125 until instructed otherwise, perhaps on an accelerated voting timetable), others will need to be made in accordance with the directions of a wider constituent body. In most instances, this will be a group of the senior creditors that comprise a prescribed majority, but there is no standard approach to setting voting thresholds required to approve a particular senior creditor decision.126 Many transactions adopt three thresholds: simple majority (which is usually either over 50 per cent or at least 66 and two-thirds per cent), super-majority (which is generally between at least 66 and two-thirds per cent and at least 85 per cent), and unanimous. Confusingly, decisions labelled ‘unanimous’ are seldom what the title would suggest (because in any context a true unanimity requirement cedes too much power to individual creditors, as it enables them to hold everyone else to ransom). Unanimous senior creditor decisions are most likely to be decisions of all the various senior creditor groups (or all those that vote by a particular cut-off time).
7.168 Decisions with respect to acceleration (and so enforcement action) sometimes use a stepped voting structure, often coupled with a special category of ‘fundamental’ events of default (p. 211) (such as non-payment, insolvency, or loss of concession rights). Such an arrangement might allow a particular majority of creditors to direct acceleration following the occurrence of an event of default and a reduced majority to do so after (say) 90–180 days in relation to a fundamental event of default and after 180–360 days after an ordinary event of default.
7.169 Figure 7.1 sets out an example of a four-tier threshold decision matrix and identifies the type of decisions within each category.
Subordinated creditor protections
7.170 The subordinated creditor protections built into an intercreditor agreement are designed for the protection of mezzanine creditors and third-party subordinated creditors (i.e. not including sponsors that have provided subordinated debt in place of true equity capital). There are essentially three key protections:
(1) the covenants by the senior creditors not to amend the terms of the senior creditor documentation otherwise than within defined parameters;
(2) a call option in relation to the senior debt; and
(3) rights relating to the enforcement of security by the senior creditors.
Any rights given to subordinated creditors in relation to the enforcement of security will, however, be limited and are built on the premise that, by agreeing to participate in the financing, the subordinated creditors have accepted the risks that go with their subordinated status, the main risk being that, in the final analysis, they will lose all their investment before the senior creditors lose any of theirs.
7.171 Of the three protections mentioned in paragraph 7.170, the call option is perhaps the strongest because it gives the junior creditors the ability to control the enforcement of security where they are confident that the process will realize sufficient proceeds to discharge the senior debt and some of the junior debt (but more of the junior debt than would be discharged if the senior creditors were left in charge of the process). It is not, however, a particularly attractive protection (and may even be a double-edged sword)127 because it requires the relatively small subordinated lender group to buy the debt claims of the substantially larger senior creditor at par (which will represent a substantial premium over its then market price given that the option only arises where the loan is in default). In the world of commercial lenders, it is unlikely that a mezzanine lender group would ever be able to finance the purchase of the senior debt in these circumstances: faced with the prospect of the loss of their existing investment (which was the risk assumed at the start of the transaction when the project looked sound), on the one hand, and, on the other, the prospect of increasing their exposure to the project hugely at a time when the project has, for one reason or another, proved that it is failing, a credit committee is hardly likely to (p. 212) (p. 213) go for the second option. However, where the subordinated debt has been provided by an arm of the country in which the project is located, different considerations may apply. The call option may, for example, provide a means for the state to assume control of the entire financing and its restructuring, which may be more attractive than leaving the process to market forces (albeit that they could probably achieve this easily enough, and perhaps at lower cost, without the call option).
7.172 The covenants from the senior lenders not to amend their credit agreements other than within certain defined parameters are designed to protect both creditor groups. This allows the senior lenders some flexibility to restructure the terms of their debt if necessary, but at the same time limits the extent of the changes to ensure that the junior lenders will have the right to approve changes that will have an effect on them.128 When it comes to the enforcement of security, the protection that it is reasonable to expect an intercreditor agreement to afford to the junior creditors is twofold: first, the enforcement process itself should be transparent, the ideal (from the junior perspective) being an auction arrangement orchestrated by a respected (and suitably experienced) investment bank instructed by the senior creditors following a degree of consultation with the junior creditors (recognizing that it is the concept and extent of such consultation rights that will be the most sensitive area for negotiations between the senior and junior creditor groups); second, the junior creditors should be entitled to make offers to buy the relevant assets and, for that purpose, receive all information in relation to the assets that is provided to other potential bidders. Junior creditors may request a right to match the highest bid from other bidders, but that is not an attractive proposition from the perspective of the senior creditors because of the reaction of the other potential bidders (who can be expected to be reluctant to invest the time and money necessary to make a serious (i.e. fully diligenced) bid in the knowledge that, even if they produce the highest offer, their bid may be unsuccessful).
7.173 Intercreditor agreements will restrict hedge providers from exercising termination rights under their hedging agreements129 with the project company except in limited circumstances.130 The three key circumstances are considered in paragraphs 7.174 to 7.176.
7.174 Where the project lenders have accelerated the project loans. Once problems on a project have reached the point where the project lenders have decided to accelerate their loans and enforce their security, the hedge providers will be entitled to terminate their hedging agreements and so quantify the termination sums that are owed to them. The termination sums are treated as principal, with the result that, going forward, the termination sums owed to each hedge provider will constitute its debt, both for voting purposes and for the purposes of distributions on account of the proceeds of the enforcement of the security.
(p. 214) 7.175 Where the project company has failed to make a scheduled payment to the hedge provider under the hedging agreement (and the payment default continues for a specified period). If a hedge provider is not being paid, then it will be entitled to exercise its right to terminate its hedging agreements in accordance with their terms. The logic behind giving the hedge providers this right of termination despite the fact that the lenders do not have the equivalent right131 is that:
(1) in circumstances where the hedge providers are not receiving scheduled payments under their hedging agreements the lenders are not receiving their interest payments (because all such amounts are paid at the same level in the waterfall);
(2) non-payment of interest under the various credit agreements will be an event of default (either immediately or after a very short grace period), which entitles the lenders to accelerate their loans and enforce their security rights (and in particular, their security rights over any cash that might be in any of the project accounts which would be paid to lenders on an enforcement but which, until then, is required to be paid to suppliers and other creditors higher up the waterfall);
(3) assuming the continuation of the circumstances giving rise to the diminution in income (or increase in expenses) that gave rise to the non-payment in the first place,132 the decision by the lenders not to accelerate their loans and enforce their security (in relation to which the hedge providers have no say (because until their hedging agreements are terminated they have no debt claims to vote)) can legitimately be said to be the reason why the default is continuing; and
(4) whilst it is reasonable for the lenders to take a decision not to assure payment of sums owed to themselves (albeit that a minority of the lenders may have voted against the decision), it is not at all reasonable for them to harm others by their decision where those others have no vote in relation to the decision.
The simple solution133 is to give the hedge providers the right to terminate their hedging agreements if the non-payment continues for a specified period. Ultimately, the lenders are most likely to want to see their interest payments kept current (which automatically results in the same treatment for the hedge providers given that both payments are at the same level in the waterfall), so it is likely that the point will only arise in reasonably extreme circumstances. The point is thus not as significant as it might appear. One point to note in this context is that this is the sort of situation in which the senior lenders may wish to make use of the senior ‘headroom’ referred to in footnote 130: an amendment to a credit (p. 215) agreement to allow a short-term advance to avoid the default will be preferable to allowing the hedge provider to terminate its hedging agreements if they are out of the money from the project company’s perspective. (The period that the intercreditor agreement stipulates that the hedge providers must wait before they become entitled to terminate their hedging agreements thus needs to be set by reference to the likely time that it will take for the lenders to consider the circumstances, come up with a solution, take whatever votes need to be taken, and implement the resulting decision without being unduly burdensome for the hedge provider.)
7.176 Where the right of termination arises as a result of illegality or the occurrence of certain tax events. In these circumstances, a hedge provider will be entitled to terminate its hedging agreement, with the project company’s obligation to pay the resulting termination sums being treated as a prepayment. (In practice, however, it is more likely that the hedging agreements will be transferred to another hedging provider by novation without being terminated.)
7.177 Although bondholders will almost always rank pari passu with the senior bank lenders in a project financing, the bank lenders will usually have the benefit of a considerably more extensive covenant and events of default package than the bondholders. Over the life of the project loan, the project company is likely to seek, and the bank lenders are likely to grant, a number of amendments, waivers, and consents in respect of that package. On the other hand, a bond financing typically features a very large constituency of (usually passive) investors, making the process of obtaining amendments or waivers from bondholders expensive and laborious. As a result, bond covenants are usually structured as ‘incurrence’ covenants (which are only capable of being breached by positive action on the project company’s part, for example incurring further borrowings or granting security for existing borrowings) as opposed to ‘maintenance’ covenants (such as the financial ratios which are affected by the project company’s trading performance).
7.178 The voting arrangements in the intercreditor agreement will reflect the separation of the bond and bank lender covenant packages and, as a rule, will minimize the circumstances in which the bondholders’ consent is required with respect to decisions, whether the decisions relate to the making of amendments of any of the project agreements or other transaction documentation or to the taking of enforcement action as a result of the occurrence of events of default. Thus, intercreditor agreements often provide that bondholder consent need not be obtained in relation to amendments to project agreements which are approved by the requisite majority of other senior creditors or to amendments to the other senior financing agreements that are made within defined parameters.134
(p. 216) 7.179 The entitlement of bondholders to vote with respect to decisions to accelerate and enforce security will depend on the event of default. Fundamental events of default such as non-payment and insolvency and the loss of concession rights will invariably be events that entitle bondholders to vote on the decision to accelerate all the senior project debt and enforce security. A breach of the financial covenants in the common terms agreement, however, should be something in respect of which the bondholders do not vote (although the terms and conditions of the bonds will provide for automatic acceleration of the bonds should the other senior creditors decide to accelerate their claims as a result of the breach, albeit that this is very unlikely).
7.180 Intercreditor agreements invariably include provisions for the indemnification of, in particular, the security agent and, if there is one, the intercreditor agent. These indemnification provisions are often expressed to oblige each creditor to indemnify the relevant agent (on a several basis) against a proportion of any losses, costs, expenses, and liabilities that the agent might incur in performing its functions under the intercreditor agreement and the other financing documentation, each creditor’s proportion being the same as the proportion borne by the amount of its overall participation in the financing to the aggregate of the participations of all the creditors. This is the same formulation that is adopted in countless syndicated credit agreements for the indemnification of the facility agent thereunder by the members of the syndicate and may well prove acceptable to the agents under an intercreditor agreement relating to a project where the project debt does not include an issue of bonds in the capital markets. However, where the creditor group includes a group of bondholders, an indemnification provision along these lines (whilst apparently fair as between the creditors) will not provide the agents with the level of protections that (quite reasonably) they will expect. This is because whilst it may be135 that the agents technically have a contractual claim against each bondholder for the bondholder’s pro rata share of the relevant liabilities, it will be virtually impossible for them to enforce those contractual claims because in all probability they will simply not know (or be able to establish) the identities of the bondholders.
7.181 Some intercreditor and security agents are content to rely on provisions in the agreements pursuant to which they are appointed136 that entitle them to refrain from doing anything until they have been indemnified to their satisfaction (or have had their potential costs ‘pre-funded’ to an acceptable level), and so accept a several indemnity from all the creditors or senior creditors (notwithstanding the limited value of the indemnity from the bondholders) on the basis that if they were ever to be instructed to do something, they could (p. 217) require indemnification from a small group of creditors that specifically does not include any of the bondholders.
7.182 One solution that can work where an agent is unwilling to accept an indemnity from bondholders is for the intercreditor agreement to provide that the indemnity is provided by the senior creditors other than the bond trustee, and then provide that all amounts that may be required to be paid out under the indemnity (together with funding costs attributable to the payments) must be reimbursed in full out of any security enforcement proceeds before any distributions are made on account of other claims for costs and expenses that the creditors (including the bond trustee) may have under the financing documentation. Bond trustees may not, however, readily agree to this arrangement, because ordinarily they would expect to receive distributions on account of their costs and expenses before payments are made to other creditors.
2 This is particularly important under English law (where pre-contractual negotiations will, as a general rule, be superseded by the written agreement of the parties), but not, it appears, under continental civil law regimes. Article 4.3 of the UNIDROIT Principles of International Commercial Contracts, UNIDROIT, 2004 and Art. 5.102(a) of the Principles of European Contract Law (1999) allow recourse to prior negotiations to ascertain the ‘common intention of the parties’, as does the United Nations Convention on Contracts for the International Sale of Goods (1980). See also C. Valcke, ‘On Comparing French and English Contract Law: Insights from Social Contract Theory’, 16 January 2009, at <http://ssrn.com/abstract=1328923>, mentioned favourably by Lord Hoffmann in Chartbrook Ltd v Persimmon Homes Ltd  UKHL 38, which case also reviews the English case law authorities on the point.
4 Under the domestic law of certain jurisdictions, such as Saudi Arabia, an obligation to pay interest is unenforceable because it is contrary to sharia’a law. In these cases, other fee or profit-sharing structures may be adopted to provide the lenders with an economic return in relation to their stake in the transaction. These are more fully explored in Chapter 11.
5 The same market considerations often drive the stance taken by the lenders in relation to commercial points on the documentation, because potential syndicate members will typically baulk when faced with material provisions in the financing documents that are ‘off-market’ or otherwise unusual.
6 Most, although not all, ECAs have their own preferred form of credit agreement (particularly if they are lending directly to the project company). The principal features of ECA facility agreements (including the ways in which these differ from credit agreements used in other financings), as well as those of the recommended form of credit agreement for use in export finance buyer credit transactions supported by an ECA which was published by the LMA in April 2018, are explored in Chapter 8.
7 This additional protection is of less significance where the monies advanced are held in an account in respect of which the project company has granted the lenders a security interest. It is also unlikely to be of benefit in cases where the law of the jurisdiction in which the project company is incorporated (which is the law that would ultimately regulate the project company’s insolvency) does not recognize trusts.
8 See Quistclose Investments Ltd v Rolls Razor Ltd  AC 567; Twinsectra Ltd v Yardley  1 AC 384. Most credit agreements also provide that the lenders have no obligation to monitor the application of funds borrowed. As well as helping to ensure that the lenders’ equitable claims to funds held by the project company are not conditional on anything more than the project company’s promise to use the funds for the agreed purpose, provisions along these lines also ensure that the lenders cannot be said to have assumed any sort of duty to monitor the project company’s use of funds to other stakeholders (such as the project company’s shareholders).
9 See the discussion in para. 12.27 in relation to The South African Territories, Ltd v Wallington  AC 309 and the question of whether the remedy of specific performance is available in relation to obligations to lend.
10 Loan drawdowns are often directly tied to progress under the construction contract and a credit agreement may therefore require that, on or immediately prior to each drawdown, the technical adviser certifies that certain ‘milestones’ have been achieved or that a prescribed degree of construction has been completed. The delivery of the appropriate certificate showing that the milestone has been met is thus the condition precedent to the drawdown.
11 The classic example of a ‘potential’ event of default arises where a credit agreement stipulates that a payment default constitutes an event of default if it continues for (say) three days. No actual ‘event of default’ can occur until the end of the specified three-day period. However, for so long as the non-payment is continuing, the project company can be said to be in default of its obligations under the agreement. It is this default that constitutes the ‘potential’ event of default.
12 Where the requested waiver relates to a material matter, lenders may grant the waiver subject to conditions that they regard as appropriate in the circumstances (such as requiring the breach to be remedied by a longstop date, the delivery of an updated financial model, and the provision of updated information). (Lenders may also seek to grant waivers subject to the provision by the sponsors of additional financial support, but conditions of this nature will be particularly unattractive to the sponsors and so difficult for them to accept, with the result that the point will involve considerable negotiation.) Such waivers will generally be granted on the basis that the project company’s failure to satisfy or comply with the conditions will constitute an event of default, thereby giving the lenders a further opportunity to assess their ongoing participation in the project, but care must be taken with the preparation of the waiver documentation to ensure that this is in fact the result.
13 Whilst the requirement for unanimity means that a single lender could prevent an entire syndicate from making the initial advances under the credit agreement, the right to sign-off on the initial conditions precedent is often something required by the terms of the lenders’ internal credit approval processes. Borrowers sometimes seek to minimize the risk of delays associated with this approach by attempting to secure the lenders’ agreement on the form and content of as many of the documentary conditions precedent as possible before the credit agreement is signed. Whilst this may help, it is unlikely to eliminate the risk entirely, in particular because lenders are often unwilling to commit the required resources to approve conditions precedent documentation until they have completed their due diligence and have a watertight assurance that they will participate in the financing (which of course will only be the case once the credit agreement has been signed).
15 Depending on the size of the syndicate, obtaining sign-off from all lenders on the conditions precedent documentation can be a time-consuming and lengthy process, and in particularly large syndicates, where it would not be efficient to seek the consent of each of the banks, the agent may agree to operate on a ‘no objections’ basis and agree to confirm satisfaction of conditions precedent unless one or more of the lenders directs otherwise. The requirement for lender sign-off on conditions precedent can, therefore, have timing implications for a proposed signing or closing, and should always be taken into account in structuring the transaction schedule.
16 The fact that the lenders’ obligations to lend are several means that a lender’s failure to make its share of a requested drawdown available will leave the project company with a shortage of funds. Historically, credit agreements were drafted on the implicit assumption that lenders would remain solvent (and as such able to comply with their lending obligations) and so did not include provisions to address a lender’s failure to lend. The 2008 financial crisis, with its resulting bank collapses, prompted a new approach, with the result that it is now common for credit agreements to include provisions designed to mitigate the project company’s risk of a lender’s failure to lend (irrespective of the reason for the failure), usually along the lines of the ‘Defaulting Lender’ provisions in the LMA’s form of leveraged credit agreement, which operate to facilitate, among other things, the replacement of a lender in circumstances where it does not, or cannot, perform its obligations under the credit agreement. Note that a lender will not fall within the LMA’s standard definition of the term ‘Defaulting Lender’ if it is disputing in good faith whether it is contractually obliged to make the requested loan (e.g. because it believes that a condition precedent has not or cannot be met). A short grace period will also usually apply if the lender’s failure to lend is attributable to an administrative error or a disruption to the payment systems or financial markets that is beyond the lender’s control.
18 See, for example, the ‘Impaired Agent’ provisions in the LMA’s leveraged form of credit agreement. Note that the rationale for the development of these provisions is much the same as that which led to the development of the ‘Defaulting Lender’ provisions referred to in footnote 16.
21 The general principle of ‘bail-in’ is that shareholders and creditors are expected to take a loss on their respective holdings, as opposed to a ‘bail-out’ whereby, as was commonly seen following the 2008 financial crisis, external parties (typically governments using public funds) would rescue the distressed institution. Note that this is one of several tools available to regulators attempting to stabilize a distressed institution and that the exercise of such powers remains subject to the overriding principles of the BRRD which includes the ‘no creditor worse off’ principle, which requires that the application powers of the BRRD must not result in creditors incurring greater losses than would be the case if the firm were to be wound down under normal insolvency proceedings. Thus, the risks to counterparties under the BRRD are no greater than those they would face in ordinary insolvency.
22 The UK is currently scheduled to leave the EU on 29 March 2019. It is too early to know what impact this will have on the syndicated loan market and much will depend on the final negotiated withdrawal terms. Although the market is actively considering the impact of so-called ‘Brexit’ and potential risk mitigants, the inherent uncertainties in this process mean that it is, and will continue to be, difficult to assess the implications for credit documentation, particularly in relation to European legislation such as the BRRD. If the UK’s withdrawal from the EU is not accompanied by EEA membership or some other suitable transitional arrangement in relation to the BRRD, English law governed contracts that contain liabilities within the scope of Art. 55 would need to include ‘bail-in’ provisions. There is currently no legal requirement for English law governed contracts to contain a ‘bail-in’ provision but, as the 29 March deadline approaches, project companies and lenders may begin to consider safeguarding against this risk. The implications for existing English law governed agreements that do not contain the requisite bail-in provisions remain to be seen.
23 Note that, as well as new contracts, this will apply to loan transfers where the transferee lender is an EEA financial institution and the credit agreement into which it transfers is governed by the law of a non-EEA country. Non-EEA law governed credit agreements entered into prior to 1 January 2016 are unlikely to contain ‘bail-in’ provisions and it may not, therefore, be commercially viable for the transferee lender to include the requisite ‘bail-in’ clause in the facility agreement at the time of its transfer.
24 A ‘material amendment’ is broadly defined to mean any amendment which affects the substantive rights and obligations of a party to the relevant contract (Art. 47 of Commission Delegated Regulation (EU) 2016/1075 of 23 March 2016). Note that the amendment does not have to affect the liabilities of the financial institution. In practice, lenders tend to take a relatively conservative view as to whether or not something constitutes a ‘material amendment’ and, aside from genuine administrative amendments (such as changes to contact details and the correction of typographical errors), there tends to be a preference, when amending existing finance documents, to err on the side of caution and include an appropriate ‘bail-in’ clause.
26 Even if the original lending syndicate does not involve an EEA lender, where syndication is permitted (as is often the case) there is a possibility that a European bank may become party to the documentation in the future. It is not, as a matter of law, necessary to ‘future-proof’ the credit documentation by including a ‘bail-in’ provision if there is no European bank involved at the time the finance documents are drafted, but it may be commercially expedient to consider doing so.
28 Note that the LSTA’s ‘Defaulting Lender’ definition has been expanded to include lenders that become subject to ‘bail-in’ action in order to facilitate the replacement of such lenders. This approach has not, however, been adopted by the LMA.
29 The actual proportion of excess cash that will be ‘swept’ to prepay loans will differ from project to project and can be variable (so that, for example, less excess cash is applied to prepayment if the project company out-performs its financial targets by an agreed margin).
30 Similar ‘sweep’ and special reserve arrangements may be used in other circumstances as well. They are sometimes seen where an important contract has not been signed or a government permit is not in place by a given date, or, in the case of oil and gas or mining projects, where reserves are being depleted at a faster rate than that projected in the financial model.
31 This is the so-called ‘yank the bank’ clause, which provides a means of avoiding deadlock where a decision on a transaction requires all the banks in the syndicate to agree to it. Rather than using a very high majority lender threshold (90–95 per cent) for the decision (which some lenders will simply not agree to as a matter of principle), the project company will have the right to prepay dissenting banks as long as lenders constituting (say) an 80–85 per cent majority have agreed to it. Some borrowers are negotiating changes to the ‘Defaulting Lender’ provisions discussed in footnote 16 so as to give the project company the right to prepay a Defaulting Lender (in addition to the basic right under the standard LMA provisions right, which is to cancel the Defaulting Lender’s undrawn commitment and arrange for it to be assumed by a new or an existing lender).
32 Irrespective of the merits on either side of this debate, certain DFIs, MFIs, and ECAs will not, as a matter of internal policy, participate in a transaction unless the project company accepts an obligation to pay a prepayment premium when making a voluntary prepayment.
33 In the case of the nationalization event, the reduced revenue may be attributable to the fact that there will in future be a need to pay for the use of the pipeline or port facilities now owned by the government. In the case of the insurance event, whatever the asset produced will no longer be something that the project company will have available to sell (or will be something that the project company now needs to purchase from a third party to enable it to make something else to sell).
34 Liquidated damages paid for delays in achieving completion will be applied to meet incremental interest and other costs attributable to the delays. See para. 5.29.
35 Although not widely used in project finance transactions, a downgrade in a borrower’s (or a guarantor’s) credit rating below a prescribed minimum will sometimes trigger a prepayment obligation in relation to those facilities provided by institutions whose internal guidelines permit them only to make ‘investment grade’ investments (which is often the case with pension funds and insurance companies). However, a drop in credit rating is more likely to trigger the imposition of a higher interest margin than an obligation to make a prepayment unless the prepayment will result in a reversal of the downgrade (which is a possibility where the downgrade is attributable to over-leveraging and the prepayment is made with the proceeds of new equity).
36 This contrasts with the ‘individual facility’ events of default and mandatory prepayment events that can be triggered in financings for projects with ECAs and DFIs as lenders (where, for example, there is a failure to maintain eligible content or environmental covenants that are peculiar to particular lending institutions) and which inevitably give rise to the question of where the repayment obligation will appear in the waterfall (as to which see paras 7.114–7.118).
37 From a lender’s perspective, giving the project company the seemingly reasonable right to allocate a prepayment to the repayment schedule as it may elect has the disadvantage of also providing scope for the manipulation of the project company’s cashflows to an extent that avoids breaches of financial ratios that would otherwise have occurred. Whilst a breach of a financial ratio is never good news for any stakeholder, the main purpose of the ratios is to provide a mechanism to monitor the performance of the project so that problems can be identified (and dealt with) sooner rather than later. Introducing a means of masking a cashflow problem therefore interferes with this early warning system and so arguably works to the disadvantage of all parties.
38 Whilst exceptions are few and far between, they do exist. Lenders may, for example, be prepared to make loans to a project that has had to be restructured on a basis that includes an interest holiday of some sort, perhaps in return for an equity interest in the project in lieu of the foregone interest.
39 On 27 July 2017, the Chief Executive of the Financial Conduct Authority (FCA), Andrew Bailey, announced the FCA’s intention to cease compelling panel banks to submit rates to facilitate the calculation of LIBOR after the end of 2021. Whilst of itself this does not mean that LIBOR will cease to be available at the end of 2021 (because if banks are prepared to provide rates without compulsion from the FCA, there is no reason why ICE Benchmark Administration Ltd (which is the company that administers LIBOR) cannot continue to publish the rate), when coupled with the increased reputational and regulatory risks involved in supplying LIBOR rates following the scandal associated with the manipulation of the interest rates used to set LIBOR which began to unfold in 2012, the absence of compulsion from the FCA will inevitably result in a reduction of the number of banks that will be willing to be involved in the LIBOR process. Lenders are therefore being urged by the FCA actively to consider appropriate alternatives to LIBOR on the basis that LIBOR will be discontinued (at the very least, in its current form) at the end of 2021. The market is currently considering a range of alternatives, but the process is still ongoing and there is no current consensus as to the rate (or rates) that will replace LIBOR. Once there is a generally accepted alternative, existing credit agreements with customary LMA-based interest provisions will need to be amended to reflect the new reference arrangements; until then, most new credit agreements are likely to incorporate provisions along the lines of the LMA’s ‘Replacement of Screen Rate’ clause in order to facilitate appropriate amendments with some level of majority lender consent (because without such provisions the necessary amendments would usually require the consent of all the lenders).
40 Although the interest charged in relation to most project loans is calculated on a floating rate basis, lenders generally require borrowers to hedge their interest rate exposure in relation to at least some of the project debt by entering into interest rate hedge agreements, thereby effectively converting the floating rate interest on the hedged portion of the debt into a fixed rate. See paras 4.54–4.57.
41 Following the LIBOR scandal (as to which see footnote 39) many banks are reluctant to agree to act as reference banks in syndicated facilities. However, notwithstanding this reluctance, it is not uncommon for credit agreements still to include reference bank provisions as a fallback option, typically on the basis that the reference banks will be appointed by the agent following consultation with the project company if and when required (instead of being named in the credit agreement).
43 In transactions in the London market, the proportion is usually in the order of 30–35 per cent by share of the facility rather than a majority, although with particularly large syndicates a smaller percentage is likely to be more appropriate. In the US market, the tendency is for the threshold to be the same as that used to define the majority lender group entitled to approve normal amendments and waivers under the credit agreement.
46 See para. 9.27 et seq.
54 For purposes of FATCA, a ‘material modification’ is defined by reference to section 1.1001–3(e) of the US Treasury Regulations, which determines when a ‘significant modification’ of a debt instrument has occurred. Treas. Reg. § 1.1471–2(b)(2)(iv). The general rule is that a modification (or a series of modifications) will be significant if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are ‘economically significant’. There are also a number of specific rules relating to changes to the yield, timing of payments, the identity of the obligor or security provider, the nature of the debt, and accounting or financial covenants.
56 Obligations that produce foreign passthru payments (i.e. obligations that will not produce US-source payments) will be grandfathered if they are outstanding on the date that is six months after the publication of the final rules on foreign passthru payments. Treas. Reg. § 1.1471–2(b)(2)(i)(B). No such rules have yet been published.
60 See ‘Model Intergovernmental Agreement to Improve Tax Compliance and to Implement FATCA’, available at <http://www.treasury.gov/resource-center/tax-policy/treaties/Pages/FATCA.aspx>.
61 A list of the jurisdictions that have entered into an IGA can be found on the IRS website. See <https://www.treasury.gov/resource-center/tax-policy/treaties/Pages/FATCA.aspx>. As of the date of writing, the following jurisdictions have already signed a Model 1 IGA with the US: Algeria, Angola, Anguilla, Antigua and Barbuda, Australia, Azerbaijan, Bahamas, Bahrain, Barbados, Belarus, Belgium, Brazil, British Virgin Islands, Bulgaria, Cambodia, Canada, Cayman Islands, Colombia, Costa Rica, Croatia, Curacao, Cyprus, Czech Republic, Denmark, Dominican Republic, Estonia, Finland, France, Georgia, Germany, Gibraltar, Greece, Greenland, Grenada, Guernsey, Guyana, Holy See, Honduras, Hungary, Iceland, India, Ireland, Isle of Man, Israel, Italy, Jamaica, Jersey, Kazakhstan, Kosovo, Kuwait, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, Mauritius, Mexico, Montenegro, Montserrat, the Netherlands, New Zealand, Norway, Panama, Philippines, Poland, Portugal, Qatar, Romania, Saudi Arabia, Singapore, Slovak Republic, Slovenia, South Africa, South Korea, Spain, St Kitts and Nevis, St Lucia, St Vincent and the Grenadines, Sweden, Thailand, Trinidad and Tobago, Turkey, Turkmenistan, Turks and Caicos Islands, Ukraine, United Arab Emirates, the United Kingdom, Uzbekistan, and Vietnam. As of the date of writing, the following jurisdictions have already signed a Model 2 IGA with the US: Armenia, Austria, Bermuda, Chile, Hong Kong, Japan, Macao, Moldova, San Marino, Switzerland, and Taiwan. The following jurisdictions have reached Model 1 agreements in substance with the US, but have not yet signed an agreement: Cabo Verde, China, Dominica, Haiti, Indonesia, Malaysia, Peru, Serbia, Seychelles, and Tunisia. The following jurisdictions have reached Model 2 agreements in substance with the US, but have not yet signed an agreement: Iraq, Nicaragua, and Paraguay. Additional FATCA Documents are available at <http://www.treasury.gov/resource-center/tax-policy/treaties/Pages/FATCA-Archive.aspx>.
65 The LMA noted its understanding in the publication that it is unusual for financial institutions to act as a ‘Qualified Intermediary’ that has elected to assume primary withholding responsibility in relation to their agency businesses. 2014 Summary Note on FATCA, LMA (9 June 2014) (revised 5 November 2015), at 2.
67 Credit agreements governed by New York law also include provisions designed to protect lenders against changes in law, generally along the lines of the provisions to be found in the LSTA (Loan Syndications & Trading Association) model forms of agreement, which apply both to changes in law regarding capital or liquidity requirements that reduce the rate of return on a lender’s capital (or the capital of an affiliate of a lender) as a result of its participation in the facility and to changes in law which (i) introduce or modify reserve, special deposit, compulsory loan, insurance charge, or similar requirements against assets of, deposits with, or credit extended by lenders; (ii) subject lenders to taxes linked to their loans or commitments that do not fall within (and are not excluded from) the scope of the principal tax protection provisions in the credit agreement; or (iii) impose on lenders or the London interbank other conditions or costs that affect their loans, in each case which increase the cost to lenders of participating in a facility (or reduce amounts they receive as a result of their participation).
68 The most notable examples of these regulatory changes are the introduction of the package of measures known as ‘Basel III’ (and the reform of ‘Basel III’, which was published in December 2017 and is known as ‘Basel IV’), which seeks to impose new capital requirements, liquidity standards, and leverage ratios on banks, and the US Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, which seeks to impose more stringent capital requirements on US financial institutions.
69 Although anti-corruption provisions are often included alongside those relating to sanctions, they tend to be less complicated and more limited in scope. Project companies are, therefore, generally willing to provide the lenders with some comfort regarding their compliance with anti-corruption legislation and the existence of adequate policies and procedures. The leveraged form of credit agreement published by the LMA contains anti-corruption representations and undertakings that can be, and often are, used as a starting point for negotiations by lenders. That said, the precise wording of such representations and undertakings still tends to be negotiated on a transaction specific basis.
71 LMA Guidance Note: United States and European Union Sanctions <https://www.lma.eu.com/documents-guidelines/documents>.
74 For this reason, certain lenders are also insisting that the amendment or waiver of any sanctions-related protection requires unanimous lender consent (or, at the very least, the consent of specific lenders).
75 The operating phase waterfall set out in para. 7.118 contemplates that the prepayment would rank after regular debt service and the funding of debt service and other required reserves but before voluntary prepayments and cash sweep prepayments.
76 Repetition of representations throughout the term of the loan is particularly common in non-US law-governed financings. It is relatively standard practice in New York law-governed financings for representations only to be repeated during the loan availability period.
77 See, for example, the discussions regarding ‘thin capitalization’ rules and capital maintenance in paras 12.15–12.18.
78 There is some merit to this argument, although it ignores the lenders’ contribution to the pre-completion revenue stream. It may be better, therefore, to regard the issue as being neither right nor wrong either way and, rather, as a point for commercial negotiation between the sponsors (who will want to count the revenue as equity to enhance their return) and the lenders (who wish to have the revenue applied to reduce the amount of debt they make available so as to reduce their risk). See also the discussion in para. 7.117.
79 The ratio is limited to principal because the calculation of the net present value of the project’s future revenues involves the discounting of those revenues by reference to anticipated interest rates.
80 Assumptions cover all predictable factors that will affect a project’s cashflows. They thus include things such as interest rates, inflation rates, foreign exchange rates, the project’s fuel and raw material costs, the price of the project’s output in the intended market, labour and other operating costs such as insurance, transportation, and marketing costs, and the project’s output capacity. The list goes on and varies depending on the project.
81 The definitions used will generally be based on the terminology used by IFRS (the international accounting standards within the meaning of IAS Regulation 1606/2002) with appropriate adjustments to reflect particular principles used by the project company in the preparation of its financial statements.
82 It is also the case that credit agreements often test the project company’s entitlement to incur replacement debt (i.e. debt the proceeds of which are used to refinance project debt borrowed during the construction phase of the project) by reference to the assumptions in the original financial model, but this is really more of a restriction on refinancing the construction debt with (less expensive) post-construction debt than anything to do with the assumptions themselves.
84 See paras 12.31–12.41.
85 The credit agreement will also prohibit distributions whilst a default or potential event of default is continuing and may also stipulate that distributions may only be made in accordance with any applicable rules on the maintenance of capital (as to which see paras 12.16–12.18) or otherwise permitted by law.
86 A credit agreement is unlikely to allow the project company sufficient flexibility to expand a project at its whim. However, if the project company is able to demonstrate that, notwithstanding the resulting increased debt burden, it will still be able to meet the specified financial ratios, the credit agreement may well permit the project company to proceed with its expansion plans, perhaps with the consent of a reduced majority of the lender group than would ordinarily be required for such a decision (particularly, if the expansion was envisaged at the outset of the original project).
87 The entitlement to exercise these rights (which may be conditional on periods of notice) is generally conferred on the lenders constituting a specified majority (in terms of their participations in the financing). Whilst this can be the same as the majority required in other contexts, this will not necessarily be the case. As well as providing that these rights may be exercised as directed by the specified majority lenders, credit agreements frequently give the lenders’ agent a discretion to exercise the rights without reference to the lenders. Whilst it is unlikely that an agent would ever elect to exercise such a discretion (for fear of being accused—by someone with the benefit of hindsight—to have done so improperly), the discretion is included so that the agent can take appropriate steps for the benefit of its principals should circumstances so dictate.
88 Should the lenders themselves exercise their step-in rights in relation to a particular contract, they will be assuming direct contractual obligations to the relevant contract counterparty to do whatever the contract obliged the project company to do thereunder. The use of special purpose companies as the vehicles that actually ‘step-into’ these contracts minimizes the risks assumed by the lenders in these circumstances, particularly those that might flow from tortious claims.
89 See the discussion on direct agreements in paras 12.105–12.114.
90 Whilst an event of default may entitle the lenders to threaten to accelerate and enforce their security (and so appears to enable them to demand whatever new financing terms they want to insist on), the threat may be somewhat hollow because the possible disadvantages to the lenders in carrying out their threat are potentially significant. Quite apart from the fact that this approach is likely to mean that the lenders do not recover their loans in full, such actions may carry with them significant reputational risk.
91 As noted in para. 7.116, the contractual provisions regulating a project’s bank accounts may be embodied in a common terms agreement or in a stand-alone accounts agreement. References in this chapter to there being an ‘accounts agreement’ are intended to capture both approaches.
92 It may be that foreign exchange or other regulatory restrictions in the jurisdiction in which a project is located prohibit the project company maintaining bank accounts outside the jurisdiction. If that is the case, the lenders will not get what they want, with the result that any risks they have identified with the project company holding only onshore accounts will need to be addressed in another way.
93 It will seldom be practicable to have all the accounts offshore because a project will need local bank accounts from which to pay day-to-day local currency expenses, even though the bulk of the project’s funds can be held in overseas accounts.
94 Separate project accounts will be maintained for contingency-based receipts, such as insurance recoveries, with monies in those accounts being paid out to meet reinstatement costs or, in the case of proceeds under business interruption policies, to meet operating expenses and debt service costs.
95 The financing documentation will also feature a waterfall dealing with the application of the proceeds of the enforcement of security, but whilst this works in the same way as the accounts agreement waterfalls in that it establishes a priority of payments regime, it is not part of the normal accounts agreement structure.
96 Scheduled payments under interest rate hedging agreements (as distinct from termination payments) will ordinarily be treated as interest payments for the purposes of distributions under the waterfall.
99 Standby letters of credit are generally preferred to guarantees, because guarantees carry with them the suggestion that they are secondary obligations of the issuing bank whilst letters of credit do not. The letters of credit or on-demand guarantees will normally be required to be issued in favour of the lenders’ agent and should provide for payment on demand in the simplest terms possible in order to minimize the risk of challenge to the issuing bank’s liability to pay. The accounts agreement will then authorize the agent to make demands if funds are not credited to the account as and when stipulated in the financing documents or if the letter of credit or on-demand guarantee is not renewed well before its expiry date or is not replaced within a specified period after a drop in the issuing bank’s credit rating below the required minimum.
102 The accounts agreement would also stipulate when the agent would be entitled to give the relevant direction to the account bank, which would normally be following the occurrence of an event of default or potential event of default.
103 Subordination can be structural or contractual. Structural subordination involves the mezzanine lenders making their loans available to a borrower that is a direct or indirect shareholder of the project company (to which the senior facilities are made available). Contractual subordination arrangements are, as the name suggests, arrangements that depend on subordination agreements for their efficacy rather than on the general principle that a shareholder’s claim against a company is always subordinate to the claims of the company’s creditors.
104 The theory here is that if the problem only causes an issue with the senior cover ratios, only the senior lenders should have an event of default available to them to negotiate better terms, as discussed in para. 7.109, or, put another way, unless there is a major problem (or a mezzanine payment default) the mezzanine lenders, as subordinated creditors, should not have the same rights to participate in any restructuring discussions with the project company and the sponsors that might be initiated by the senior lenders. It is worth noting in this context that, because the mezzanine financial ratios are customarily looser than the senior ratios, the cross-default clause in the mezzanine facility agreement will only be triggered upon acceleration of the senior debt.
105 Even if the mezzanine facility agreement includes the same covenants as the senior credit facility (and so includes corresponding lender consent requirements), the intercreditor agreement will usually include ‘drag-along’ provisions such that the mezzanine lenders will be deemed to have given their consent if the senior lenders have given consent under the corresponding provision in the senior credit agreement.
106 See para. 7.118.
107 The terms of the senior and mezzanine facilities will be such that principal and interest on both facilities falls to be paid on the same dates so that available cashflow on a payment date is always applied to discharge the senior liabilities due on that date before the mezzanine liabilities. Similarly, the intercreditor agreement will restrict the acceleration of the mezzanine facility, with the result that the combination of the subordination provisions and the security enforcement waterfall will mean that senior liabilities must be discharged before mezzanine liabilities.
109 See para. 7.170.
110 As discussed in para. 7.141, interest costs attributable to the EBL will constitute project costs in the same way that interest on the main project loans constitute project costs, and this will be reflected in the project’s financing plan.
111 The senior lenders are not usually willing to allow equity bridge funding for all the sponsors’ contributions, usually insisting that the sponsors make conventional contributions of around 10 per cent of the project costs. Some jurisdictions also have minimum capitalization requirements that mean that a project company’s shareholders will be obliged to subscribe and pay for a minimum level of share capital.
112 It may not always be possible because, for example, the eligibility requirements for ECA financings, or the need to take title to specific assets in an Islamic financing, require a different disbursement sequence.
113 Whether they should be secured is something of a moot point. Any benefit that is derived from the security will be derived at the expense of the project company’s unsecured creditors and it is difficult to see why the claims of the EBL lenders and the sponsors should prevail over the claims of (say) a third-party supplier that has delivered goods to the project but not been paid given that the EBL (which is simply a mechanism for the deferral of the sponsors’ equity contributions) should really be treated as equity.
115  1 WLR 758,  2 All ER 390. The decision of the House of Lords makes it clear that transactions may be cut down on grounds of public policy where they are intended to avoid basic insolvency principles such as mandatory set-off and pari passu distribution amongst unsecured creditors.
116 See the judgments of Vinelott J in Re Maxwell Communications Corporation plc (No. 2)  AER 737 and Lloyd J in Re SSSL Realizations (2002) Ltd (formerly Save Service Stations Ltd) (in liquidation); Manning v AIG Europe (UK) Ltd; Robinson v AIG Europe (UK) Ltd  EWHC 1760 (Ch).
117 Many project financing intercreditor agreements are considerably simpler than the LMA form in many ways. However, when it comes to the voting rights of the different creditors and creditor groups in a complex project financing, the opposite is true. Apart from complexities that can arise merely through the diversity of the different lending groups in a project financing, one of the main reasons for complexity in this area is that, even before anything goes wrong on a project, a significant number of the lenders (from the commercial bank that acts as the project’s ‘technical bank’ to the ECA that assumes responsibility for overseeing the environmental impact studies that the project company or the sponsors produce for a project) will be actively involved in technical aspects of the project. Such involvement gives rise to detailed monitoring arrangements and often to a need for different amendments and waivers (and therefore more procedures for different approval arrangements) than might be expected in relation to non-project financings.
118 A financing plan that relies on (say) a mezzanine facility for 10 per cent of the project’s capital cost because the limit to the senior debt is 60 per cent and the sponsors wish to limit their equity to 30 per cent could well be jeopardized if the senior portion of the financing has been syndicated on the basis that the entitlement of the mezzanine lenders to require the enforcement of the security package is much more limited than might normally be expected. It is quite possible that in such a case none of the mezzanine lenders will agree to participate in the transaction as proposed, with the result that the sponsors will either need to persuade the senior lenders to make concessions to the mezzanine lenders (no doubt in exchange for an increase in their own fees) or increase their equity contributions. Either way, there will be upset all round and delays in concluding the financing arrangements.
119 See, for example, chapter 3: Conflicts of interest in the SRA Code of Conduct 2011 published by the UK Solicitors Regulation Authority at <http://www.sra.org.uk/solicitors/handbook/code/part2/rule3/content.page>.
120 See para. 7.134.
121 If the sponsors provide subordinated debt in place of true equity capital, their claims as subordinated creditors would be ‘deeply subordinated’, by which is meant that they have very few rights at all as creditors. Their main protection is that by virtue of their shareholding in the project company they will be aware of, and would usually expressly approve any changes to, contracts to which the project company is a party.
122 See the discussion in para. 15.106.
123 As a rule, even after the hedge counterparties’ claims have crystallized as a result of the termination of their hedging transactions, they will be limited to voting in relation to decisions with respect to the enforcement of security and a limited number of particular decisions (such as changes to the waterfall) which could have a direct impact on their interests.
124 Quite apart from the fact that the funding sources are disparate, certain multilateral and public-sector creditors such as ECAs may (and, by the terms of their constitutions or OECD guidelines, may be obliged to) insist on veto rights with respect to decisions on particular matters (notably social and environmental matters and issues related to corrupt practices). Sometimes consents and waivers require both a majority of the creditors by value and the approval of a minimum number (or a majority by number) of a particular type of creditor (such as ECAs) within a class of creditors. State funding for strategic projects may be made on terms that the state has a so-called golden vote for use in relation to decisions on particular issues (or even a veto on all decisions).
126 As mentioned in para. 7.166, the key drivers for determining the thresholds will be precedent transactions in the relevant sector, and the identity and character of the creditor group.
127 The existence of the call option in favour of the mezzanine lenders in Barclays Bank Plc and others v HHY Luxembourg SARL and another (Rev 1)  EWCA Civ 1248 was a factor that was taken into account in the court’s construction of the release provisions in the intercreditor agreement. The relevant provision specifically authorized the release of claims against a company being sold pursuant to an enforcement of security but made no reference to the release of claims against that company’s subsidiaries. The Court of Appeal held that the provision should be construed to confer authority to release the claims against the subsidiaries despite the objections of the junior creditors, one of the reasons for this construction being that the junior lenders did not need the protection that a literal construction of the clause gave them because they always had the right to buy the senior creditors’ claims and take over the enforcement themselves.
128 For example, it is common for the intercreditor agreement to include provisions that allow the senior lenders to increase their loans within a senior ‘headroom’ limit (which, depending on the project, is generally set somewhere in the range of 5–10 per cent of the senior debt outstanding at the time) by means of repayment deferrals or new advances so that they can manage reasonably short-term liquidity problems that the project might face.
129 For an analysis of interest rate hedging in project finance transactions, see para. 4.55 et seq.
130 The financing documentation will provide that only lenders and hedge providers that become parties to the intercreditor agreement will be ‘secured parties’ for the purposes of sharing the benefit of the security package for the financing.
131 A particular senior lender or group of senior lenders will only be entitled to accelerate for non-payment of an amount (whether of principal or interest) if the requisite majority of senior creditors has approved that acceleration (in accordance with the terms of the intercreditor agreement).
133 An alternative solution is of course to entitle the hedge providers to vote in relation to a decision to accelerate and enforce the security. However, because the basis on which the hedge providers’ votes would need to be calculated for these purposes will depend on market rates at the time of the vote rather than at the time that the hedging agreements were concluded (because this is the basis on which their termination sums would be calculated), and because there is no way of predicting what those markets rates will be, this solution means that the hedge providers may have much larger (or smaller) voting entitlements than anyone anticipated when the financing documentation was being finalized, making much of the analysis and negotiations that went into establishing the various voting majorities needed for the decision to accelerate (as to which see the discussion in paras 7.164–7.168) largely academic.
134 The parameters will probably not be the same as those that define the circumstances where other creditors are required to consent to a change. For example, an intercreditor agreement might require that bondholders approve the incurrence of new debt which would result in the project company’s leverage exceeding a specified maximum even though the borrowing was within the agreed senior headroom (as to which see footnote 128) (and so did not require mezzanine lender approval). Contrariwise, the terms of the intercreditor agreement could be such that, whilst the incurrence of the new debt might require the approval of the mezzanine lenders (because it was more than the agreed senior headroom), bondholder consent was not required because the resulting leverage was lower than the specified maximum.
135 Merely providing in the intercreditor agreement that a bondholder will have an obligation to indemnify the agents will not, of itself, achieve this result because the bondholder is not a party to the intercreditor agreement. In order to impose the obligation on the bondholders, the bond documentation (the governing law of which may well be different to the governing law of the intercreditor agreement) will need to operate in a manner that actually makes them parties to the intercreditor agreement from the time they become bondholders.
136 The provisions for the appointment of the security agent in the form of intercreditor agreement published by the LMA, for example, entitles the security agent to refrain from acting in accordance with any instructions it may have been given by a creditor or group of creditors until it has received such indemnification and security as it may, in its discretion, require for costs, losses, and liabilities in complying with those instructions (including payment in advance and despite the fact that it is indemnified under the transaction documents).