Previous chapters have considered how credit support for loans is provided to potential lenders through factors intrinsic to the project itself and various types of third party support. This section discusses two additional factors that provide protection and comfort to lenders: (1) how assets of the project are used to provide collateral for loans to the project; and (2) the role of direct agreements in a project’s security package.
A. PURPOSE OF SECURITY
As an effective method of credit support, security over project assets is generally not as useful as the size, quality and sustainability of the project’s revenue stream or many of the other forms of support discussed previously. Nonetheless, there are several reasons why lenders generally insist on security over project assets. When a lender obtains a security interest, it normally obtains the right to possess and/or sell the collateral on the happening of certain specified events such as SPV payment default. In theory, the lenders could use this right to take control of the project assets and use them to continue to operate the project, or sell them to help repay outstanding debt. However, for the lender to be able to do this effectively, the assets would need to be in good operating condition, have ascertainable value, and be marketable without lengthy
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enforcement proceedings or government consents as a condition of use or sale.
In addition there are other more defensive reasons for taking security in project assets.
They are:
• Priority in Bankruptcy: As secured creditors, lenders would have priority rights in liquidation or bankruptcy;
• Blocking Rights: Lenders could prevent the SPV from selling the assets or prevent another creditor from acquiring security over the assets; and
• Negotiating Leverage: The fact that lenders have the right to enforce their security interests is often useful as leverage when negotiating with the SPV, which may mean that debt owed to a security holder is more likely to be repaid.
B. THE IMPORTANCE OF HOST COUNTRY LAWS
The laws of the host country will generally govern all matters relating to the creation, the perfection (registration or recordation) and enforcement (exercise of remedies) relating to security in project assets. This means that a major issue for legal due
diligence is the content of the host country laws relating to security. These laws will vary greatly from country to country and depend, in part, on whether the country has a civil or common law tradition. The threshold question for due diligence is under what circumstances, and to what extent, the
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laws of the host country permit the seizure and sale of project assets or allow a creditor to take possession or ownership of project assets in order to operate the project. In short, how are security interests created, perfected and enforced in the country concerned?
C. DUE DILIGENCE ISSUES RELATING TO SECURITY
To answer these general questions, a number of subsidiary issues need to be considered, including:
1. ASSETS SUBJECT TO SECURITY INTERESTS
The threshold question is what kind of assets are available for inclusion in a project’s security package under host country law. Specifically, is collateral or security limited to tangible fixed assets or may security interests be obtained in movable assets and/or intangible assets like concession rights and future assets?
2. TYPE OF SECURITY INTERESTS
A related question is what types of security interests or instruments are permitted under host country law. For example, the due diligence needs to consider whether any or all of the following instruments can be used: mortgages over land and fixed property;
various types of security interests in movable property; a pledge of shares in the SPV;
and fixed and floating charges over assets.
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3. THE FLOATING CHARGE CONCEPT
A floating charge “floats” over the borrowers’ assets and fixes on those in possession when enforced. It enables ordinary business to be conducted before the floating charge fixes by allowing property to flow in and out of the inventory or possession of the debtor.
Key questions for due diligence are: whether a lender can obtain a floating charge or whether its security interest has to be fixed on specific assets from the time that it is created; and if floating charges can be created, what assets may it cover?
4. PROCESS FOR OBTAINING SECURITY INTERESTS
Host countries will have a different formalities and procedures for obtaining security interests, and a part of due diligence is to understand exactly what needs to be done in
the country concerned to perfect the interest. For example, what consents are required?
Does the lender need to take possession of an asset to perfect a security interest or are non-possessory interests permitted? Are there special signing and notarial requirements?
Are there limits on the amount of security? How should the document be registered or recorded? What are the fees and the basis for calculating them?
5. ASSIGNMENT
Some countries may have restrictions on the assignment of security interests. For example, can the interest be assigned to a trust to be held by a
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trustee for the benefit of the lenders? In the case of syndicated bank loans, permitting such assignment would facilitate changes in the composition of the syndicate without the necessity of re-registering the security each time a bank is added or subtracted. When assigning a contract related to security interests is one also assigning performance obligations or the obligation for prior liabilities associated with the assets such as environmental pollution? An assignment of collateral should, if possible, assign the beneficial rights, but not the duties, to the assignee.
6. ENFORCEMENT
There is great variation in how security interests are enforced from country to country.
The lender due diligence process needs to determine exactly what needs to be done in the host country to convert the lender’s security interest to ownership or control of assets that can used by the lenders or sold for cash to help repay outstanding loans. Security interests will be less valuable to lenders if the host country has lengthy, costly enforcement procedures where the outcome may be uncertain. For example, it is important to determine whether a lender may take possession of an asset and enforce its right in the property without a court proceeding and order.
7. RIGHTS AFTER ENFORCEMENT
Some countries may place limits on what a lender can do with an asset once it has successfully enforced its rights and taken ownership of the asset.
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For example, can the creditor operate the project as well as sell the assets? Can it assign the asset at this stage? If it wants to sell the asset, does it need court approval and/or do the proceeds of the sale need to be in local currency?
8. LIMITATION ON THE USE OF SECURITY
The great uncertainties that exist in many host countries in connection with the creation, perfection, and enforcement of security interests and the time and cost involved often diminish the importance of security over project assets in determining a project’s bankability and the terms and conditions of its loans. This is one reason that lenders generally also insist on a pledge of the sponsor’s shares in the SPV which may enable the lenders to exercise the rights of owners and not creditors and, in this way, escape some of the potential limitations inherent in the taking of security.
D. DIRECT AGREEMENTS
Another problem related to the taking of security over all project assets (including contractual rights of the SPV) is the fact that a party to one of the project agreements may not give its consent to a lender taking an interest in the SPV’s rights under the agreement. A direct agreement is a contract between the lenders, the SPV and/or a party to one of the various project agreements designed, inter alia, to deal with this problem.
The two main purposes of entering into a direct agreement are: (1) to facilitate the ability of the
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lenders to take over a project by stepping into the shoes of the SPV/borrower if it defaults on its loan obligations; and (2) to prevent the parties to the project agreements from terminating them without the consent of the lenders. To accomplish these objectives, clauses commonly found in direct agreements include:
• consent by parties to the project agreements to the creation of security in, or the assignment of, the SPV’s rights under the project agreements;
• agreement by the parties not to exercise termination rights without giving notice to lenders;
• agreement by the parties that they will not terminate the project contract if lenders exercise their security rights;
• agreement by the parties that the lenders can assume the rights of the SPV under the contracts; and
• agreement by the parties and the government that all relevant licenses, consents and permits can be transferred to the lenders.
The SPV, the parties to the project agreements and the government generally accept direct agreements as they keep the lenders involved in trying to solve any problems with the operation of the project and may create lender obligations or limits on lender action.
As an alternative to direct agreements, it
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may be possible to include provisions creating lender rights in the various project documents themselves and then rely on the contract law doctrine of third party beneficiary which is explicitly recognized by statute in some countries.
E. TYPICAL PROJECT FINANCE SECURITY PACKAGE
A typical security package for a major project financing would involve security over all of the project’s tangible and intangible property rights and might include:
• mortgages or other security interests over all tangible property (land, equipment and buildings);
• an assignment of the SPV borrower’s interest in all project documents, including the concession;
• an assignment of the SPV borrower’s rights under all insurance contracts;
• a charge in favor of the lenders over any Collateral Accounts holding security interests or Project Accounts involving collection and disbursement of the project’s cash flow;
• a subordination agreement for the subordination of all loans made by any subordinated lender;
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• a share pledge agreement pledging all shareholders share capital in the SPV/Borrower; and
• any Direct Agreements with parties to the various project documents.
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