LexisNexis Practical Guidance®

The five main project parties in a typical project finance transaction (see Introduction to project finance) are:

• •the sponsor;
• •the project vehicle (referred to in this guidance note as the “project company”) which is typically the borrower of the project loans;
• •contractors and sub-contractors;
• •suppliers; and
• •off-takers.

This guidance note explains the roles of the five main project parties in a typical project finance transaction.

See Key project parties and their roles.

The five main finance parties in a typical project finance transaction (see Introduction to project finance) are:

• •the lenders;
• •hedging counterparties;
• •the arranger;
• •the facility agent; and
• •the security trustee/security agent.

In addition to these parties, there are usually other roles to be played in the financing arrangements and/or on behalf of the finance parties. These include:

• •the account bank; and
• •specialist advisers to the finance parties.

Some of these additional roles can be filled by one or more of the banks or financial institutions already involved in the transaction.

This guidance note explains the roles of the main finance parties in a typical project finance transaction.

See Key finance parties and their roles.

Most projects require some form of debt financing. In fact, a common feature (see Common features of project finance transactions) of project finance is that there is a significant level of debt (capital-intensive) and there is also a high expected return. The debt element of the funding for a project is typically referred to as “project finance”.

While no two project finance transactions are ever the same, there are certain key steps that are fundamental to securing financing for a project. It is useful to note that publicly procured projects are likely to have more steps than privately initiated projects. Those key steps for both publicly procured and privately initiated projects are explained in this guidance note.

See Key steps in financing a project.

Due diligence is an important part of any commercial finance transaction, but it is absolutely critical in project finance transactions because projects are inherently risky (see Identifying and analysing project risks and risk allocation — part 1).

Many projects share certain key areas of focus for the due diligence process, including feasibility, legal and political matters, environmental and social matters, insurance requirements and tax and accounting issues. This guidance note provides a summary of those areas and guidance on the type of information that the lenders will require. Importantly, this guidance note explains the concept of “bankability” in the context of a project finance transaction. “Bankability” determines whether or not lenders are prepared to provide financing for a particular project.

See Conducting due diligence and understanding “bankability”.

A project may be financed from several sources. The structure of any particular transaction will largely depend on the source of finance. This guidance note provides an overview of selected common sources of funding, including:

• •loans from commercial banks (such as in the form of syndicated loans);
• •finance provided by large institutional investors, such as superannuation funds and pension funds;
• •capital markets financing (bonds); and
• •assistance provided by export credit agencies.

This guidance note also considers the issue that Australia’s major trading banks often struggle to provide the long-tenor debt required to finance large projects on terms that are competitive with their overseas counterparts, and how the gap in the market for longer-tenor debt can be filled.

See Source of funding in project finance.

In a typical project finance transaction (see Introduction to project finance), the lenders (see Key finance parties and their roles) rely heavily on the revenues generated by the project for repayment of the loan (see Common features of project finance transactions).

As a result, project finance lenders will impose strict restrictions on how the project company (see Key project parties and their roles) uses its cash. This guidance note explains how the lenders commonly impose these restrictions in project finance transactions. Importantly, this guidance note explains how a system of bank accounts is established and the funds to be deposited into each account and that may be withdrawn from each account are detailed in the loan agreement. Common accounts that may be required in a project as covered by this guidance note include:

• •revenue account (also sometimes characterised as an operating account or proceeds account);
• •construction account;
• •insurance proceeds or compensation proceeds account;
• •debt service reserve account;
• •maintenance reserve account;
• •ramp-up account;
• •lock-up account; and
• •distributions account.

See The use of project accounts in project finance.

Before embarking on a potential project, the proposed sponsor (see Key project parties and their roles) must prepare a “feasibility study” (see Conducting due diligence and understanding “bankability”) to assess the project's viability. If the sponsor decides that the project is viable, it will often then use the feasibility study to explain the project to potential lenders (see Key finance parties and their roles) and any equity investors.

A feasibility study analyses the key elements of a proposed project, and an important part of the feasibility study is the “financial model”. This guidance note explains what the financial model is, what it is used for and how it is checked by the lenders. It also explains the concept of the “base case” financial model, and what is a “model audit”.

See Financial model.

A key element of the solution to managing many project risks (see Identifying and analysing project risks and risk allocation — part 1) is to transfer that risk to insurers by way of one or more insurance policies. As such, ensuring that a comprehensive, adequate and robust insurance package is in place during all phases of a project (see Key steps in financing a project) is of critical importance to financiers (see Key finance parties and their roles).

Project finance lenders usually require an expert insurance adviser to report on the types of insurance that are appropriate for the project as well as levels of cover, excesses and exclusions. The lenders will want to be sure that risks associated with the project are covered by insurance as much as possible.

Among other things, this guidance note explains the types of insurance in project finance and considers matters relating to uninsurable events, key insurance covenants commonly included in the finance documents and the role of an insurance specialist in a project finance transaction.

See Project insurance — role, scope and issues.

As one would expect, there are many documents involved in any project finance transaction. Projects are typically facilitated through an entity that is owned or controlled by the project sponsor, and this entity is usually a special purpose vehicle (SPV) set up by the project sponsor specifically for the project. Against this background, this guidance note provides an overview of the principal documents that the SPV will enter into in order to procure the performance of the project. The principal documents are broadly divided into five categories, being:

• •the finance agreements;
• •the investment agreements;
• •the construction contract(s);
• •the operating contract(s); and
• •the offtake contracts.

See Typical documents in a project finance transaction.

Many of the standard finance documents used in a straightforward syndicated transaction will also be required in a project finance transaction. Project financing is, after all, a form of syndicated lending.

This guidance note provides an overview of the following key finance documents:

• •a term sheet that sets out the key commercial terms of the transaction, which is often coupled with a mandate letter;
• •a facility agreement, which is often coupled with a common terms agreement;
• •an inter-creditor agreement that governs the relationship between the project finance lenders and any other parties providing finance to the project;
• •any hedging documentation that addresses market risks associated with the financing of the project;
• •direct agreements (or tripartite agreements) that give the project lenders direct rights in respect of certain key project documents; and
• •account agreements that address the types of project accounts that are required, the cashflow waterfall, and the relationship between the borrower (project company), the lenders and the account bank.

See Key finance documents in a project finance transaction.

This guidance provides an overview of a selection of key project documents:

• •offtake contracts under which a third party (the offtaker) agrees to buy a certain amount of the product produced by a project at an agreed price;
• •concession contracts that govern the relationship between the host government (or governmental authority) and the borrower;
• •construction contracts that are entered into with appropriately-skilled contractors to provide construction services; and
• •operation and maintenance contracts that are entered into with operators to provide operation and/or maintenance services.

See Key project documents in a project finance transaction.

In a project finance transaction, facility agreements include specific conditions that need to be satisfied before funding will occur. These conditions are known as conditions precedent, or “CPs”. There are potentially serious consequences of CPs not being satisfied, for example, the lender is not obliged to provide funding.

This guidance note explores the two types of CPs that lenders will require before funds are made available to the borrower. They are:

• •documentary CPs; and
• •factual CPs.

See Key terms in project finance documentation and drafting tips — conditions precedent.

Typically, representations and warranties are given on the date the facility agreement is signed by the borrower and any security provider.

Legal representations deal with the legal status of the borrower, any guarantors and any security providers, the ability to enter into the finance documents and compliance with the relevant entity’s own constitution and other laws.

Commercial representations tend to relate to the assets of the borrower and its ability to carry on its business. They also confirm that the business and assets are not at risk due to third party claims or failure to comply with laws or regulations.

This guidance note outlines the key matters to consider when drafting representations in a project finance transaction.

See Key terms in project finance documentation and drafting tips — representations and warranties.

In a project finance transaction, undertakings (or covenants as they are sometimes called) are extensive. They are promises given by the borrower and sometimes other obligors (for example, guarantors or security providers) to the lender to perform or not perform certain actions. The breach of an undertaking often triggers an event of default.

In contrast to representations, undertakings will remain in force throughout the life of the facility.

Undertakings are designed to ensure that the borrower develops, constructs and operates the project within the parameters agreed with the lenders. Like undertakings in any other form of financing, they are intended to ensure that the lenders find out about problems as quickly as possible. This guidance note outlines the key matters to consider when drafting undertakings in a project finance transaction.

See Key terms in project finance documentation and drafting tips — undertakings.

For project finance lenders, understanding the financial health of a project is critical. In a typical project finance transaction, the project is the borrower’s only source of income from which to repay the debt.

Project finance lenders monitor the financial health of a project by using a number of different financial covenants, as explained in this guidance note, including:

• •debt to equity ratio;
• •debt service cover ratio;
• •loan life cover ratio;
• •project life cover ratio; and
• •minimum tail requirement.

This guidance note also considers when financial covenants are tested in project finance transactions and the use of financial ratios in project finance transactions, for example, as a default trigger.

See Key terms in project finance documentation and drafting tips — financial covenants.

This guidance note explains the types of repayment provisions, prepayment provisions and cancellation provisions that can typically be found in a project finance development term loan facility. This explanation includes examples of how these provisions may differ to the typical repayment, prepayment and cancellation provisions typically found in a corporate term loan facility. It also discusses some of the reasons for these differences, for example, the long term nature of a development term loan facility, the fact that during the development and/or construction phase a project does not generate any revenue and the inter-relationship the repayment and prepayment provisions have with the technical monitoring of a project both during the development and construction phase and during the operating phase of the project.

See Key terms in project finance documentation and drafting tips — repayment, prepayment and cancellation provisions.

Events of default give lenders a mechanism under which they can, if they choose, take action against a borrower for breach of its obligations under a facility agreement or if certain other events occur. In a project finance transaction, where the lenders are typically solely or largely reliant on the revenues of the project for repayment of the loan(s), the lenders will often want to include events of default which may help them to identify issues with the project’s progress at an early stage to enable them to impose obligations on the borrower to take any remedial steps in good time. Among the most severe consequences of an event of default in a project finance transaction is the right for a lender to cancel its commitment.

Many of the usual events of default for a typical syndicated loan facility will also apply (in some form) to a project finance transaction. For example, failure to pay any amount under the finance documents when due, and breach of a financial covenant.

A key focus of this guidance note is to consider the types of additional events of default which may apply in a project finance transaction, which are categorised into:

• •events of default relating to project parties;
• •events of default relating to project documents; and
• •events of default relating to the project and its ownership.

See Key terms in project finance documentation and drafting tips — events of default.

A force majeure event is an event that occurs that is beyond the control of the project parties. The event prevents a party, or multiple parties, from fulfilling their contractual obligations. It can materially and adversely affect the completion or operation of a project.

Force majeure risk is particularly acute for the project lenders as any delay or suspension to the generation of project revenues can have serious consequences for the ongoing viability of the project, and, in extreme circumstances, a lengthy delay caused by an event of force majeure may result in termination of the project and insolvency of the borrower.

This guidance note explores the identification and management of force majeure risks, and drafting considerations relevant to force majeure provisions in project documents.

See Key terms in project finance documentation and drafting tips — force majeure clause.

An applicable law clause and a jurisdiction clause are different. A contract can have different law and jurisdiction, that is, parties to a contract can nominate different law and jurisdiction.

With regards to an applicable law clause, the commercial effect of a contract could vary depending on the law and jurisdiction the contract is interpreted in. For this reason, it is essential that the project parties to a contract agree on these matters.

With regards to a jurisdiction clause, it often accompanies any applicable law provisions in contracts and is designed to specify the jurisdiction in which the parties agree disputes will be adjudicated.

This guidance note provides legal practitioners with commentary to help draft (and review) applicable law and jurisdiction clauses in project documents.

See Key terms in project finance documentation and drafting — applicable law and jurisdiction clauses.

Security in a project finance transaction is particularly important because the borrower is typically a special purpose entity which is set up specifically to develop and operate the project. In such cases, the borrower will have no credit history and its only assets are likely to be the project assets.

Some of the reasons for taking security in a project finance transaction include:

• •giving the project lenders priority over unsecured creditors of the borrower (typically the project company);
• •giving the project lenders a better chance of recovering their money in an insolvency scenario;
• •giving the project lenders the right to appoint a receiver or administrator if certain conditions are met; and
• •providing a way for the project lenders to control the borrower’s and any other security provider’s assets.

This guidance note outlines the key assets of a project, looks at what to consider when putting together a security package for a project finance transaction, and overviews the types of security in a project finance transaction. Guidance is also provided on possible alternatives to taking security, and matters relating to onshore and offshore security.

See Typical security package in a project finance transaction.

Land (or real property) is commonly offered as security for a loan. This is the case for project finance transactions where the project site represents a significant proportion of the borrower’s assets.

Generally, security in respect of land extends to fixtures that form part of the land, unless the contrary is expressly provided for.

This guidance note explains some key matters relating to taking security over land located in Australia in a project finance transaction, including matters relating to creating a legal mortgage and an equitable mortgage over land. Guidance is also provided on key provisions of a mortgage over land in a project finance transaction, including key covenants and common representations and warranties.

See Taking and registering security over assets relating to the project — real property.

Other than real property, key assets of a project includes various personal property. In short, personal property is any form of property, other than land or a right or entitlement under a Commonwealth, state or territory law that declares that the right or entitlement is not personal property for the purposes of the Personal Property Securities Act 2009 (Cth) (PPS Act).

The PPS Act is a law about security interests in personal property, and the operation and application of the PPS Act is very relevant in project finance transactions. A personal property security is created when a secured party, such as a project lender, takes an interest in personal property of a grantor, such as a project company as borrower, as security for a loan or other obligation, or enters into a transaction that involves the supply of secured finance (project finance is a type of secured lending).

Part 1 of this three-part guidance note overviews the taking and perfecting of a security interest over shares and a security interest over bank accounts. Part 2 overviews the taking and perfecting of a security interest over contractual rights and a security interest over receivables. Part 3 overviews the taking and perfecting of a security interest over a project company’s assets by way of a general security deed.

See Taking and perfecting security over assets relating to the project — personal property — selected key examples part 1.

See Taking and perfecting security over assets relating to the project — personal property — selected key examples part 2.

See Taking and perfecting security over assets relating to the project — personal property — selected key examples part 3.

In most cases, a legal mortgage will have priority over an equitable mortgage, even if the equitable mortgage is prior in time, provided the legal interest was taken in good faith, for value and without notice. This is a key reason why project lenders will prefer a legal mortgage over an equitable mortgage.

A legal mortgage is a mortgage that complies with all of the requirements imposed by common law and by statute for the creation of a mortgage. Importantly, under the Torrens system, a mortgage is not only required to be in writing and signed by the mortgagor, but it is also required to be registered. This guidance note explains what is the National Mortgage Form and the role of PEXA, and provides State and Territory specific guidance relating to how to register a mortgage over land in Australia.

See How to register real property security at state-based land titles office.

A security interest will have its best possible priority position, will be least likely to be lost on a disposal of the collateral, and should resist vesting in the grantor on its insolvency, if the security interest is “perfected” in accordance with the PPS Act. Registration on the Personal Property Securities Register (PPS Register) is the most common manner in which perfection is completed.

This guidance note considers some key rules relating to how and when to make registrations on the PPS Register that are of particular relevance or importance in project finance transactions.

See How (and when) to register personal property security on the Personal Property Securities Register.

In addition to ensuring its personal property security has been validity created, a project lender will want to ensure its security ranks as it expects against any other competing security interests. Disputes as to priority arise less commonly than might be expected due to the use of documents such as deeds of priority and inter-creditor agreements. However, these are only of use if the creditors are aware of each other’s security interests and agree on whose interest should take priority. Where there is no contractual agreement, the general law as to priority will apply.

This guidance note answers the question “why is it important to determine priority between competing security interests”? It goes on to consider the rules which determine the priority of competing security interests in real property where the holders of those interests have not specifically agreed an order of priority among themselves by contract, such as the first in time rule for competing registered interests.

See Determining priority in real property security.

Similarly, in addition to ensuring its personal property security has been validity created, a project lender will want to ensure its security ranks as it expects against any other competing security interests.

This guidance note considers the rules which determine the priority of competing security interests in personal property where the holders of those interests have not specifically agreed an order of priority among themselves by contract. It considers, among other things, the ”default” priority rules in the PPS Act and how the rules apply in a project finance transaction, and explores some specific scenarios in terms of determining priority in a project finance transaction.

See Determining priority in personal property security.

The order of priority between competing security interests determines the order in which each of the secured creditors can claim and be paid out on the secured property in an enforcement or insolvency scenario. This makes priority something very important in the context of a project finance transaction, where for eg, the project lenders would want to be a higher-ranking (or the highest-ranking) creditor.

This guidance note considers the contractual arrangements that can be put in place for managing priority as between security interests in a project finance transaction, in particular, regarding the use of an inter-creditor agreement. It also explains the role of a deed or priority and a subordination agreement. Importantly, legal practitioners should note that the PPS Act refers to priority agreements for security interests subject to the PPS Act as "subordination agreements". This guidance note explains this, as well as discusses the relevant model documents that legal practitioners may choose to utilise in a project finance transaction.

See Managing priority arrangements between security interests.

Enforcement is an important matter to consider. If a borrower cannot meet its obligations under a loan agreement, lenders will need to consider the options available to them in enforcing their security. For eg, project lenders would want to be able to access the project assets so that on enforcement, they can for eg, sell the project as a going concern.

It is important to recognise that for many project lenders, taking enforcement action often is seen as a last resort. A project lender would often first consider the following options:

• •refinancing, for eg, having the borrower pay off the existing loan, then enter into a new loan that has more favourable repayment conditions and/or less onerous interest rates for the borrower;
• •restructuring, for eg, making changes to the borrower’s operations so its business run more effectively and profitably so that repayment of the debt becomes more likely; and
• •the project lender or another party providing additional financing in return for further security being granted by the borrower.

Further to these points, in this guidance note, legal practitioners will find guidance regarding two main issues that a project lender should consider before enforcement, being the possibility of a consensual sale, and the validity of security. Importantly, with regards to enforcing security over real property, this guidance note explores the concept of default in mortgage enforcement, and provides an overview of the typical mortgage enforcement process.

See Enforcing security over real property.

Enforcement under the PPS Act is the key focus of this guidance note. Chapter 4 of the PPS Act contains rights and remedies of enforcement of security interests on the default under a security agreement, such as a general security deed (GSD) in a project finance transaction. This means a GSD or other security agreements do not need to include these remedies as parties to the agreement can instead rely on the Ch 4 enforcement provisions in the PPS Act.

Generally, under Ch 4, on the default of a grantor under a security agreement, the secured party can commence enforcement action, and the first step in enforcement is for the secured party to seize the collateral. If a secured party has a security interest that is subordinate to another security interest in the collateral, the secured party with the higher priority security interest is entitled to seize the collateral from the subordinate secured party. Having seized and obtained possession of the collateral, the secured party may either dispose of or retain the collateral.

While Ch 4 of the PPS Act includes enforcement provisions dealing with seizure, disposal and retention of collateral, parties in a project finance transaction can contract out of specified provisions of Ch 4: s 115, PPS Act. This, as well as rules that apply after enforcement under the PPS Act, and the effect of insolvency on personal property security, are explored in this guidance note.

See Enforcing security over personal property.

Guarantees (which often include indemnity provisions) are typically used in finance transactions (including project finance transactions) as a form of collateral for a debt. In such circumstances, they are a contractual arrangement where one party (the guarantor) agrees to answer for the liability of another party (the principal) to another party. They do not create rights over property. In this context, guarantees are characterised as quasi-security.

On occasions where a lender is not able to obtain a guarantee, comfort letters are often used. Comfort letters are generally intended to be non-legally binding, however, in certain cases, they may contain features that indicate that they are legally binding.

This guidance note explores the use of guarantees and indemnities and comfort letters in a project finance transaction. See The role of guarantees and comfort letters in a project finance transaction.