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SecurityinProjectFinance

Jan‐HendrikRöver

SECUREDLENDINGINCOMMERCIALTRANSACTIONS‐ TRENDSANDPERSPECTIVES‐

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Overview

• What is project finance?• Project finance after the financial crisis• Functions of security in project finance• What is „security“ in project finance?• Security structures in project finance• How secure is security in project finance?

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Whatisprojectfinance?Ageneraldefinition

Projectfinancingischaracterisedbyfivecriteriaandthusclearlydifferentiatedfromtraditionalcorporatelending:

BorrowerLegallyandeconomically

independentprojectcompany

Serviceofprojectloan(repaymentandinterest)

fromfuturecashflowsofprojectcompany

PurposeoffinancingFinancingofaclearlydefined(greenorbrownfield)project

Liabilityofsponsors

Nooronlylimitedrecoursetosponsors• securityinterestsofprojectcompany• (limited)securityinterestsofsponsors

Riskstructuring

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Whatisprojectfinance?TheParties

Sponsor1 Sponsor2

Projectcompany

Bank1

Bank2

Loan1

Loan2

Intercreditoragreement

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Whatisprojectfinance?TheRisks

Risksfacedbyaprojectcompanyanditslenders

ProjectRisk:Creditrisks

Projectrisk:Technicalrisks

Projectrisk:Economicrisks

Projectrisk:Politicalrisks

Projectrisk:Legalrisks

Bankrisk:Syndication

risk

Projectrisk:Forcemajeure

risks

Bankrisk:Refinancing

risk

ForprojectrisksseealsosummaryofrisksinBaselIIPrinciples,appendix 4table1(supervisoryslottingcriteriaforspecialisedlending)issuedbyBaselCommitteeonBankingRegulation(inthisrespectnotsupersededbyBaselIII);seealsoArticle87§ 5ofDirective2006/48/EC

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Whatisprojectfinance?Thetypesofprojects

Power/energy(incl.renewableenergy)

35%

Transportation/infrastructure&publicprivatepartnerships

25%

Mining

4.5%

Othersectors•Leisure&Property•Telecommunications•Petrochemicals•Industry•Water&Sewerage•Waste&Recycling•Agriculture&Forestry

23%

Oil&gas

12.5%

Percentagesrepresent2010shareofsectorintotalvolumeofprojectfinancetransactionsSource:ThomsonReutersProjectFinanceInternational

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Projectfinanceafterthefinancialcrisis(i)

• Banking world in turmoil since insolvency of Lehman Brothers (2008)• Changes in the general framework Accounting changes (IFRS 10*)

If sponsor holds majority of shares in project company he must show debt financing of project company on its group balance sheet (no off-balance sheet financing by sponsors)

Banking regulation

Higher equity requirements for „specialised lendings“**– Five types of specialized lending of which project finance is one

Banks typically use „Internal Ratings-based (IRB) Approach“ to credit risk and allocate risk weightings of up to 250%

– Supervisory slotting criteria for specialised lending

* Applicable since 1 January 2013; incorporated by Regulation (EU) No. 313/2013 of 4 April 2013** See Basel Committee on Banking Regulation, Basel III: A global regulatory framework for more resilient banks and banking systems, revision June 2011

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Projectfinanceafterthefinancialcrisis(ii)

• Change in environment for PPP/PFI projects

Coming to an end of privatisation wave Change in perception of creditworthiness of public entities (in

particular PIIGS countries [Portugal, Italy, Ireland, Greece and Spain])• Change in risk realisations: long-term assumptions in cash flow models were falsified by reality Renewable energy: wind forecasts Transportation: traffic forecasts Oil and gas: gas price development General: tax assumptions

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Projectfinanceafterthefinancialcrisis(iii)

• Changes in project finance structures Generally further increase in risk awareness and risk mitigation leading

to more complex financing structures

Increase of sponsor support (transformation of limited recourse financing)

Lower debt/equity ratios (i.e. higher equity element) More comfortable financial covenants

Shorter loan tenors / incentives for early repayment or refinancing such as margin increases over time Leading to a renaissance of quasi „mini-/medium-perm

financings“

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Projectfinanceafterthefinancialcrisis(iv)

Risk mitigation instruments

International financial institutions (A/B loan structure) European Investment Bank (EIB) initiative: Loan Guarantee

Instrument for Trans-European Transport Network Projects, LGTT (networks in the transportation, power and telecommunication sector), launched in 2008

Generally reduced availability of bank financing Increased interest in project bonds as replacement of bank

financing EIB: Europe 2020 Project Bond Initiative, launched in 2012

– First project: Natural gas storage „Castor“ in 2013

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Projectfinanceafterthefinancialcrisis(v)

Source:ThomsonReuters,ProjectFinanceReview,FullYear2012

• Bank world for project finance has contracted from its peak in 2008

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Functionsofsecurityinprojectfinance

• „Securityisashield,notasword“(PhilipR.Wood*)• Limitedmarketvalueofprojectcompany‘sfixedassets• Negative ordefensivefunctionofsecurity(exclusionofthirdpartycreditors);securityprovidespowertoenforceand/orpriorityinenforcement;enablesrestructuring Not: assignment of insurance contracts Not: security assignments of other receivables

•Management functionoffloatingcharge•Positive function:enforcementofsecurity• Priority functionofsecurityininsolvency

*ProjectFinance.SubordinatedDebtandStateLoans,1995,p.30

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Whatissecurityinprojectfinance?(i)

• „Bywayofsecurityacreditorensuresforhimselfaprivilegedstatus,either byestablishingrealrightsoverone,someorallofthedebtor‘s

assets(realsecurity)or byhavingrecoursetoathirdpartywhohasundertaken

responsibilitytothelenderforpaymentifthedebtordefaults(personalsecurity)“*

* Sir Roy Goode and Ewan McKendrick, Commercial Law, 4th ed. (London 2010)

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Whatissecurityinprojectfinance?(ii)

• Partofthedefinitionofprojectfinanceisriskstructuringwithaviewtoriskmitigation Securityinafunctionalsenseinaprojectfinancecontextis

broaderthanpersonalandproprietarysecurity Comprisesanycontractualtoolthatsecuresdebtservice

Includesfinancialcovenants Includesfurtherothercoventants Debtservicereserveaccount Controlofcashflow

BroadviewonsecurityconfirmedbyBaselII„supervisoryslottingcriteriaforspecialisedlending“(seecategory„security“)

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Securitystructuresinprojectfinance(i)

• Securityinanarrowsense(„twolayermodel“) Onthelevelofsponsors Onthelevelofprojectcompany

Includessecurityonthelevelofthegeneralconstructioncontractor(EPC);(performance‐)guaranteeofthegeneralconstructioncontractor

– Providedtotheprojectcompany– Hence,additionalsecurityassignmentofany(future)rightundertheguaranteetolender

• Furthermore,so‐called„directagreements /step‐inrights“(para.6ofSchedule2AInsolvencyAct1986)withmaincontractualpartners(operators,suppliersorofftakers)

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Securitystructuresinprojectfinance(ii)

Sponsors‘sharesinprojectcompany PledgeofsharesLevelofsponsors

Levelofprojectcompany

(continuedonnextslide)

Asset Typeofsecurity

Completionguarantee

Projectcompany‘srightstopaymentofaccountdeposits

Realestate Securityinterestinrealestate

EquipmentandmachineryFixedcharge(UK)/

Securitytransferofownerhip(GER)

SecurityassignmentofreceivablesRightsunderinsurancecontracts

Pledgeforthebenefitofbank

SecurityassignmentofreceivablesRightsundergeneralconstructioncontracts

SecurityassignmentofreceivablesRightsundersupplycontracts

SecurityassignmentofreceivablesRightsunderofftakecontracts

Sponsor‘sassets

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Securitystructuresinprojectfinance(iii)

Levelofprojectcompany

(beginningonthepreviousslide)

Asset Typeofsecurity

Paymentrightsundershareholderloans

Shareholderloansinsteadofcapitalcontributionmaybeefficientformoffinancing,sinceinterestcanbe

deductedfromtaxbase

Securityassignmentofreceivables

Negative„pledge“clause(covenantnottocreatesecurityrights

forthebenefitofthirdparties)

Nosecurityinterest;onlyobligation

(Proprietaryorquasi‐proprietary)securityinpoolofassetslikefloatingchargeofEnglishlawor

nantissementdefondsdecommerceofFrenchlaw

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Securitystructuresinprojectfinance(iv):floatingcharge

• Floatingchargeswereconvenienttoolforprojectfinancingsinthepast;theyallowedappointinganadministrativereceiverandthusmanagingprojectcompanyindefault Roleininternationalfinancingshasalwaysbeensomewhat

limitedduetothefactthatcontinentallegalsystemswerenotabletorecogniseEnglishlawfloatingcharge

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Securitystructuresinprojectfinance(v):floatingcharge

• SincethereformoftheEnglishEnterpriseActanadministrativereceivercanbeappointedonlyinexceptionalcases Pursuanttosec.250EnterpriseAct2002andsec.72BInsolvency

Act1986onlyexceptionsforso‐called„qualifyingfloatingcharges“,e.g.for (2)public‐privatepartnershipproject, (3)utilityproject, (5)afinancedproject(projectfinancing)withatotaldebt

amountofatleast£50million– Scopeof“project”unclear

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Several lenders

Syndicatedloan Sub‐participation(e.g.EBRDA/Bloan)

Securitystructuresinprojectfinance(vi):securitytrustee

Bank1 Bank2

Projectcompany

Loan2

Bank2

Bank1

Projectcompany

Loan

Loan1

Sub‐participationagreement

Inter‐creditoragreement

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• Relevantforsyndicatedloans• SecuritytrusteeunderEnglishlawforproprietarysecurityinterests• MorecomplextruststructureunderGermanlaw Non‐accessory(non‐ancillary)securityrights*

Creationfor(Germanlaw)trustee Accessory(ancillary)securityrights**

Creationforeachbankinordertosecureloanobligation– Securityholdermustalsobecreditorofthesecureddebt

Creationofsecurityforthebenefitofa(Germanlaw)trustee tosecureaparallelsecureddebt(debtacceptance[Schuldanerkenntnis])

Creation of security if there are several lendersSecuritystructuresinprojectfinance(vii):securitytrustee

* I.e. non-accessory real estate mortgage for security purposes, security transfer of ownership, security assignment of receivables** Pledge of accounts, pledge of shares, accessory real estate mortgage (the latter is not often used in practice)

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Howsecureissecurityinprojectfinance?(i)

• Thereisnodifferenceinthelegalefficiencyofsecurityinanarrowsenseinprojectfinancecomparedtoothertypesoffinancing• However,theeconomicefficiencyisquitedifferent Atleastattheearlystagesofaprojectifprojectworks(and

thererforesecurityisnotneeded)• Therefore,securityinanarrowsenseinprojectfinancehasmainlyadefensiverole Atleastattheearlystagesofaprojectifprojectworks(and

thererforesecurityisnotneeded)

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Howsecureissecurityinprojectfinance?(ii)

• However,inunderstanding project finance security structures oneshould notfocus onsecurity inanarrow senseonly There are functional security instruments used inproject

finance structures which supplement personaland proprietarysecurity

Leadsto highfinancial stability of projects(provided thatassumptions are correct)

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Germansecuredtransactionslaw Jan‐HendrikRöver,RealsicherheitenundDirektvereinbarungen,in:UlfR.Siebel,

Jan‐HendrikRöverandChristianKnütel(eds.),RechtshandbuchProjektfinanzierungundPPP,2nded.(Cologne,Munich2008)

HansjörgandJörg‐AndreasWeber,Kreditsicherungsrecht,9thed.(Munich2012)Englishsecuredtransactionslaw HughBeale,MichaelG.Bridge,LouiseGulliferandEvaLomnicka,TheLawof

SecurityandTitle‐BasedFinancing, 2nded.(Oxford2012) MichaelBridge,PersonalPropertyLaw,3rded.(Oxford2002) MichaelBridge,LouiseGullifer,GerardMcMeelandSarahWorthington,TheLaw

ofPersonalProperty(London2013) SirRoyGoodeandEwanMcKendrick,CommercialLaw,4thed.(London2010)

US‐americansecuredtransactionslaw JamesJ.WhiteandRobertS.Summers,UniformCommercialCode,6thed.

(St.Paul,Minn.2010) JamesJ.WhiteandRobertS.Summers,PrinciplesofSecuredTransactions

(St.Paul,Minn.2007)

Bibliography(i)

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EasternEuropeansecuredtransactionslaws Jan‐HendrikRöver,SecuredLendinginEasternEurope.ComparativeLawof

SecuredTransactionsandtheEBRDModelLaw(Oxford2007)Westernsecuredtransactionslaw (inparticularEuropeanUnionsecured

transactionslaws) Eva‐MariaKieninger(ed.),SecurityRightsinMovablePropertyinEuropean

PrivateLaw(Cambridge2004) HarryC.SigmanandEva‐MariaKieninger(eds.), Cross‐BorderSecurityover

Tangibles(Berlin2007) HarryC.SigmanandEva‐MariaKieninger(eds.), Cross‐BorderSecurityover

Receivables(Berlin2009) HorstEidenmüllerand Eva‐MariaKieninger(eds.),TheFutureofSecuredCreditin

Europe(Berlin2008)

Bibliography(ii)