With the dramatic plunge in oil prices, school and business shutdowns and increased concern around the impact of COVID-19 (coronavirus), the need for project financiers and borrowers to consider the implications under their finance documents has become even more pressing.
In the context of a project finance transaction, the interruption of construction or operations can have significant implications. The project company is typically a thinly capitalized special purpose vehicle and lenders have limited or no recourse to sponsors in circumstances where the project is underperforming. In this note we consider some of the issues under the finance documents for typical project finance transactions.
Is the borrower required to provide any information to the lenders?
Most facility agreements contain information undertakings with which borrowers need to ensure they comply. The scope of the undertakings will vary across different facilities, projects and sectors, but they are likely to be most extensive during the construction phase of a project. Borrowers will need to consider whether any of these undertakings have been triggered by the COVID-19 outbreak and its impact on the project. Many transactions will also give lenders the right to ask for information and so borrowers will need to ensure that they respond to any such requests within appropriate time limits.
What if expenditure increases as a result?
Borrowers may be considering steps to mitigate the impacts of COVID-19, either on the basis of good business practice, or due to an obligation to do so under its project agreement or offtake arrangements. However, lenders often have rights of approval regarding changes to the project budget and expenditure, requiring approvals of spend exceeding a certain threshold. Lenders may also have rights to request the borrower revise budgets in the event there is a change in circumstance which may affect the accuracy of the existing budget. Borrowers will need to keep these budget restrictions in mind when approving any extraordinary expenditure which may be required to mitigate the impacts of the pandemic. If provisions do not allow the requisite flexibility, a borrower may need to request a waiver from lenders of these provisions, to allow an emergency budget to be approved.
Can the lenders call a draw-stop?
If the loan is in the construction phase and has not been fully drawn, the parties will need to consider if any events have occurred which would allow the lenders to refuse to fund a utilization. Draw-stop events typically include an event of default (or potential event of default) continuing; misrepresentation; the occurrence of or a forecast funding shortfall; and delays in construction.
It is likely that COVID-19 may lead to delays in construction, for example, due to staff shortages or issues with the supply of materials. As well as a right for lenders to draw-stop, this may lead to an event of default for failure to achieve completion by the scheduled longstop date, either on that date or before, if a look-forward completion test has been included.
Borrowers need to be careful when repeating representations for the purposes of utilization to avoid misrepresentation, for example, representations relating to project compliance, no breach of law, no default or material adverse change.
Will events of default be triggered?
Aside from the completion delay event of default referred to above, there are a number of other events of default which could be triggered as a result of the COVID-19 outbreak. Many of these events will extend to the “Major Project Parties,” those parties which are fundamental to the successful performance of the project, including the construction contractor, operator, main suppliers and offtakers. These include:
Non-payment: If a project is in the operations phase, principal and interest payments are likely to be due every 3 or 6 months. Revenues for many operating projects are likely to be impacted by COVID-19. Lenders might argue that the likelihood of being unable to meet a payment known in advance is an indicator of insolvency or a potential event of default, but facility agreements typically give borrowers the benefit of the doubt until the payment default actually occurs – there is always the chance of an improvement in liquidity which means that when the time comes, the payment is made. One of the challenges with project financing is that the ability to introduce new money or bring about measures to ease short-term cash flow issues may be constrained by restrictions in the finance documents.
Financial covenants: Project finance documents include financial covenants to assess the ability of the project company to service its debt, often on a backwards-looking and forwards-looking basis. If set correctly, financial covenants will indicate early signs that a project is not performing as planned. A reduction of revenue is likely to negatively affect compliance with financial covenants leading to either an event of default of a distribution lock-up. If there is no specific provision for testing at the request of the agent on unscheduled dates, lenders will need to wait for a scheduled calculation date (coinciding with repayment dates) to assess performance. Some project finance facilities allow for equity cures if financial covenants are breached – this is a contractual right for further equity to be injected into the project to count as additional revenue or to prepay some of the debt.
Cessation or suspension of business: A suspension of all a material part of its business usually constitutes an event of default. This may extend to major project parties.
Project document events: Project finance facility agreements typically include events of default for matters occurring in respect of the project documents, for example, repudiation of project documents or non-compliance by the counterparty to a project document where this is likely to have a material adverse effect (see below).
Breach of laws: If government advice on business conduct during a pandemic or epidemic is mandatory and is not followed, this may trigger an event of default or a misrepresentation. However, where restrictions are imposed on a project as a result in a change in law, borrowers may be entitled to claim compensation or relief under the project concession agreement, which will require careful analysis.
Cross default: The project company is unlikely to have any other financial indebtedness, but Major Project Parties will. Default in respect of that indebtedness may impact on their ability to comply with their obligations under the project documents to which they are party.
Material Adverse Effect (MAE): The outbreak of COVID-19 has brought with it much talk of triggering material adverse change or material adverse effect provisions in loan agreements. Whether a material adverse change event of default will be triggered will depend on the drafting in each case. The fact that a party is located in, or is trading to, an area which is affected by the outbreak would not of itself constitute a material adverse change in its financial condition (although, depending on the surrounding facts, it might have a material adverse change in its prospects). However, if a borrower experiences financial difficulties as a consequence of the outbreak, then that deterioration in financial condition could constitute a material adverse change in its financial condition. It has been held that for an event to be material it must (a) not be temporary and (b) significantly affect the party’s ability to perform its obligations under the contract. To establish a material adverse change is inevitably going to be a highly subjective process involving careful consideration of the drafting and surrounding circumstances. It is often much easier to rely upon and enforce the more specific contractual provisions mentioned above than to argue that a material adverse change has occurred.
Insolvency: In a worst case scenario, a borrower may trigger the insolvency events of default.
What can parties do to protect themselves?
- Project companies should check their finance agreements to ensure that they continue to comply with their obligations. Even if there is no specific requirement to inform the lenders, they should consider opening communication channels early if issues are foreseen or arise.
- If they have not already done so, project companies should liaise with their project document counterparties to identify potential issues and agree how to deal with them.
- Parties should consider whether the project insurance covers any delay in construction or business interruption as a result of the outbreak. However, these policies will usually respond in limited circumstances, where there has been physical damage to the project, so policies should be checked carefully, and advice from insurance advisors sought, to ascertain the level of cover these provide.