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Bate C. TOMS
Managing Partner, B. C. Toms & Co
Legal education: Yale Law School (J.D.), Magdalene College, Cambridge University (Law Tripos I); admitted to legal practice in the District of Columbia and Virginia, USA, and in Paris, France; Chairman, British Ukrainian Chamber of Commerce (BUCC); previously the partner handling project finance at a large multinational law firm in London.
Project Finance: an Introductory Overview
Why Use Project Finance
Project Finance is one of the principal methods currently used to finance development worldwide, in particular for energy, mining, transportation, infrastructure, utilities and manufacturing facilities. Project finance has only been occasionally used in Ukraine, but it should be used much more. Greater use of Project Finance should follow from the “Strategy of Ukrainian Financial Sector Development until 2025” of 16 January 2020, of the National Bank of Ukraine, the Ministry of Finance and other financial regulators in Ukraine, that stated, among its five main priorities, promoting macroeconomic development and innovations in financing. Project Finance is an innovative way to stimulate Ukrainian economic growth. However, key problems need to be better addressed to facilitate using Project Finance in Ukraine, including in particular to provide better rule of law and greater political risk insurance.
Project Finance typically uses highly leveraged structures, which impose discipline on project participants — there is no unlimited protection based on a principal investor’s balance sheet if costs overrun. It is sometimes said that such finance can be legally complex, time-consuming and expensive to arrange. However, Project Finance offers a method to create and fund many projects that would not otherwise exist, by contractually diversifying the allocation of risks and matching sources of finance with revenue and security.
How Project Finance Functions
Project Finance is based on financing a cash flow resulting from the facilities and/or other assets created by a project that one or more sponsors initiate. Typically, pledges and mortgages over the resulting assets and revenue streams can be used to secure the project lenders, without recourse or with only limited recourse against the sponsors themselves. Such finance does not depend on the balance sheet strength of a particular sponsor or other participant. Thus, typically a project financing is “off-balance sheet” for the sponsors, i.e. it is reflected as an investment, with the debt only being shown in a footnote to the sponsor’s balance sheet as a contingent liability for the investment.
Project financings, therefore, exist largely apart from the participants own financial structures, based on a complex of contracts and arrangements to create an adequate cash flow to cover the payment of principal, plus interest, for the project loans, with a variety of pledges, mortgages and other supporting security and guarantees to ensure their payment.
There is a great variety of types of Project Finance structures. Many types of project financings, for example, are based on government concessions, that can be differentiated by ownership of the assets created, such as (1) BOT —
build, operate and transfer, and BOOT — build, own, operate and transfer, where the project assets are eventually returned to the government body that granted the concession, and (2) BOO —
build, operate and own, where the concessionaire ends up owning the facilities that it creates using the concession. Such concession type arrangements can be created as part of a private-public partnership (PPP), for which Ukraine has an initial legislative framework.
Project Finance Structures
The participants to a typical project financing and their roles are (participants may sometimes have multiple roles):
- Project Sponsors — that usually are behind the project’s creation.
- Lenders. While there may be a sole lender, usually there is a syndicate of lenders, that can include commercial and investment banks, spreading the risks, with some lenders only involved for certain stages of a project. Often for Ukraine, the lenders will include an international development bank like the European Bank for Reconstruction and Development (EBRD), the International Finance Corporation (IFC) or the European Investment Bank (EIB), that have mandates to finance development.
- Project Customers/Users. The project customers or users pay for the project’s production (“off-take”) or for use of the project’s facilities (e.g. for transportation infrastructure). They are typically the main source of funds to pay the financing.
- Contractors — that build the project and/or supply the equipment for it.
- Project Companies — typically special purpose vehicle companies (SPVs) created to act as the borrower and to own and/or operate the project, in which the sponsors or others may make equity investments.
- Insurance, Performance Bonds and other Credit Support. Guarantees, performance bonds, hedging and other credit support may be provided by various banks and other participants, including in part by sponsors, typically to address pre-construction completion risks. Insurance should apply to project assets as they are built. Political/conflict risk insurance can be important.
- Export Credit Agencies and Other Sources of Supplemental Finance. Often, to reduce dependence on main project loans, some costs can be financed by separately financing parts of a project. For example, the cost to buy equipment and other materials abroad can often be covered using export credit finance like that provided by UK Export Finance (for the UK), Hermes (for Germany) or COFACE (for France).
- Government Bodies. Governments can often be involved in a variety of ways, including (i) to provide some financial support, guarantees and/or other investment incentives, (ii) to provide concessions to use state assets or rights and/or (iii) to specially regulate the relevant business area.
- Advisors and Experts. As a project financing is typically built from an idea implemented through the creation of a complex contractual structure, high quality legal, financial and technical advisors and experts are essential.
Types of Contracts
The contractual structure to create a typical project financing involves the following types of contracts:
- Loan, Bond and other Finance Agreements, based on which the finance is provided.
- Mortgages, Pledges, Assignments and Other Security Arrangements can apply over project movable and immovable assets and contract rights to secure the lenders under the finance agreements.
- Project Construction Contracts, such as an engineering, procurement and construction (EPC) contract on the design, build and turnover of a facility for a fixed price. Projects may also be built under other arrangements, like construction management contracts with costs varying as construction proceeds, which can be more difficult to project finance.
- Concession, License or other Rights or Assets Use Arrangements. Typically, the contracts for a concession, or other project asset or exclusive rights arrangements, are with government bodies. They may range from the exclusive right to build a toll-road (e.g. for a ring-road around a city) to the right to sell energy at a particular price to a government purchaser.
- Project Operation Contracts. The project company may operate the assets or facilities itself or may contract for a third party to do so.
- Purchase/Off-take or Use Contracts. The contract for the purchase of the products produced or use of the facilities created is often the key contract around which a project financing is based. Ideally, these are long-term forward contracts, providing in advance a guaranteed market for the project, thereby ensuring revenue streams to pay the financing.
- Supply Contracts — for example, to fix long-term future raw material and other supply sources and costs.
- Agreements among Participants. These arrangements among project participants typically cover the sharing of collateral and enforcement cooperation, distribution of revenues, restrictions on, and requirements for consents to, variations in project documents, as well as shareholders agreements.
- Term Sheets, Letters of Intent, etc. A project financing idea, once developed by the financial and technical advisors and verified in a pre-feasibility study, will usually be reflected in a term sheet, and then in supporting letters of intent from the proposed project participants, based on which a financial plan can be developed, commitments in principle to fund obtained and a full feasibility study conducted. Based on such commitments and study, the actual contract documents can be negotiated and agreed.
Project Risk Allocation
A key to any Project Finance is the identification of project risks, both for the construction phrase and for operations, and the development of solutions to mitigate such risks, such as:
- Construction Completion Risk — typically the contractor should provide a performance bond from its bank to ensure that if it does not complete the project construction on time, another contractor can be brought in to do so.
- Project Solvency Risk — Project financing are typically highly leverage, which can result in solvency risks. If the SPV goes bankrupt, the contractual structure should permit re-allocation of the project’s contractual structure to a new owner, that can complete and operate the otherwise viable project.
- Currency Risk — for Ukraine, such risks include changes in currency value, convertibility and cross-border transferability, and are sometimes covered by special insurance or hedging contracts.
- Political/Conflict Risk is often important (as discussed in footnote 2 above, a solution for Ukraine is to obtain special programs for political/conflict risk insurance).
- Legal Risk — for Ukraine, the main legal risks are from (i) misbehavior within the judicial system (see the solution proposed in footnote 1), (ii) unexpected adverse changes in Ukrainian law and regulations and (iii) the discovery of environmental problems.
This brief review is just to indicate what Project Finance entails and to encourage its use in Ukraine as a financial technique for Ukraine’s future economic development.
The British Ukrainian Chamber of Commerce (BUCC), that the author chairs, has proposed establishing a Ukrainian Legal Ombudsman, as was successfully used by Sweden to transform its judicial system in the first half of the 20th century from being among the most corrupt to be the least corrupt in Europe. See “The Proposal for a Legal Ombudsman to End Abuses of Justice by Ukrainian Courts”, as published in the Kyiv Post at: https://www.kyivpost.com/article/content/business-wire/the-proposal-for-a-legal-ombudsman-to-end-abuses-of-justice-by-ukrainian-courts-by-bate-c-toms-411404.html; See also bucc.uk/articles. Such a Legal Ombudsman would provide outside review of Ukrainian judicial decisions, similar to that which is provided under Ukraine’s bi-lateral investment treaties (BITs), but the Ombudsman would relatively quickly provide such review, in time to be useful for the continuation of a project.
The BUCC has, with International Council of Business Associations and Chambers of Commerce (ICBAC), developed a proposal for special enhanced political risk insurance through the World Bank’s Multilateral Insurance Guarantee Agency (MIGA), as exists for all other countries that are experiencing conflicts, like the West Bank and Gaza, Libya and Iraq. See “The Resolution of ICBAC, The International Council of Business Associations and Chambers of Commerce in Ukraine, on the Need for the Ukraine Reform Conference on 2 to 4 July 2019 to Agree on Providing Political Risk Insurance for Ukraine Through MIGA”, as published by the Kyiv Post at: https://www.kyivpost.com/business-wire/the-resolution-of-icbac-the-international-council-of-business-associations-and-chambers-of-commerce-in-ukraine-on-the-need-for-the-ukraine-reform-conference-on-2-to-4-july-2019-to-agree-on-providing.html: and “A Commentary on the ICBAC Resolution on the Urgent Need for Greatly Increased Political/Conflict Risk Insurance for Ukraine”, as published by the Kyiv Post at: https://www.kyivpost.com/business-wire/a-commentary-on-the-icbac-resolution-on-the-urgent-need-for-greatly-increased-political-conflict-risk-insurance-for-ukraine.html; https://youtu.be/YvcCJnU0aW0; See also bucc.uk/articles.