Securing the Project
Provision of Loans to Russian Borrowers
Governing Law of the Project Agreements
Environmental Protection Matters
Political Risk Insurance
To date, relatively few project financings have been undertaken in Russia due to various factors, including the following:
- the significant amount of risk in predicting the reliability of an income stream over the life of a project;
- the regulatory and practical hurdles in the Russian market, which have discouraged developers from carrying out projects of a sufficiently significant size to justify their investments; and
- the unreliability of the Russian banking system, which has caused developers and lenders alike to consider Russian projects as high risk.
In a project financing, the parties developing the project are looking to the expected revenue stream from the project for the return on their investment. Most projects are largely financed (ie, 70% to 80%) through loans, in which the lenders' only recourse in case of a default is to the assets of the project itself. The remaining 20% to 30% of financing for the project is generally provided by investors through the purchase of equity interests.
Although project financing techniques are used to develop many different kinds of infrastructure projects, from toll roads to sports arenas, it is likely that the development of oil reserves and other natural resources, together with certain anticipated changes in the Russian utilities market, will spur the interest of investors intending to develop projects in Russia. This overview addresses the issues specific to the development of projects in Russia, including obtaining a security interest over the project assets, obtaining the necessary licences and approvals from government authorities, and dealing with currency convertibility issues.
Securing the Project
Sponsors of large and expensive projects turn to project financing because this financing is non-recourse to the sponsors.(1) Since lenders have such limited recourse in the case of a default, the project assets should include all contracts that create the revenue stream, together with all other tangible and intangible assets necessary to own and operate the project, and all related hard assets, real estate rights, government approvals, permits and technical licences. All of these assets will be pledged to the lenders to the full extent permitted under applicable law.
The advantage of obtaining a pledge on assets in Russia is that it is the only type of security interest which will give project lenders priority over most common creditors in bankruptcy proceedings (or other liquidation procedures), second only to certain types of senior creditors.(2) However, it may be difficult for a secured party to determine its priority status with respect to other secured parties. Other than for pledges of real estate and so-called 'enterprise mortgages' (pledges of all of a business's assets and operations), there is no public filing mechanism whereby a potential creditor may ensure that there are no prior liens on the collateral. As a result, the secured party must rely on the registration of pledges maintained by the debtor. If this is inaccurate, the secured party will only have a claim against the debtor but generally will not have priority with respect to holders of prior liens granted on the same collateral. In order to explain how the pledge enforcement process works, certain issues related to the enforceability of pledge agreements under Russian law are discussed below.
Governing law of a pledge agreement
Russian law allows that a pledge agreement involving a foreign party may be governed by foreign law. However, when the pledgee seeks to enforce the foreign arbitration award in Russia(3), it must do so through the Russian courts, which often tend to reconsider the case on its merits. One approach with regard to governing law is to have a pledge of property located in Russia (or of securities in a non-certificated form registered with a Russian depository, or rights pledged by a Russian entity) expressly governed by Russian law in order to increase the likelihood that it will be enforceable in Russia. Other project assets located outside of Russia should be pledged under agreements governed by a foreign law, where the legal principles that will apply in case of a dispute and enforceability of a judgment are more predictable.
Description of pledged property
While it may be the usual practice in common law-style financing agreements to refer in a security agreement to secured obligations as defined in the principal agreement, this is not generally advisable when drafting a pledge agreement governed by Russian law.
The regulations governing pledges of property in Russia are formalistic and Russian judicial practice often favours form over substance. Thus, to ensure that a court will recognize the validity of a pledge of property, the description of pledged property must be as accurate and complete as possible. It should leave no doubt as to the specific assets which are the subject of the pledge. Creditors often want a pledge to cover a whole range of the pledgor's property, including unspecified property not yet owned by the pledgor, or even 'any and all assets' of the pledgor. While these types of pledges are theoretically possible under Russian law, enforcing them may be difficult.
According to Russian court practice, pledged assets should be 'individually distinguishable' from the rest of the pledgor's property. In one court case, for example, the court found, among other defects in a contract for a pledge of a certain amount of bricks, that "there was no procedure to distinguish the pledged bricks" from others not subject to the pledge. Also, parties to a pledge are free to agree by contract that the pledge extends to the produce and income attributable to the pledged property. In the case of an enterprise mortgage, any property or intangible asset acquired, or receivables which arise during the mortgage period, are automatically included in the pledged property, unless otherwise provided by the mortgage contract.
Offshore bank accounts established by the borrower at the request of the lenders in an attempt to mitigate the various risks associated with keeping money in a Russian bank may also be pledged as security. Under Russian law, the borrower is pledging its claim against the bank with respect to these accounts, and thus the actual amount of money in such accounts may not be included as part of the collateral description.
Russian pledge law also provides that, to the extent pledged assets are insufficient to cover all of a creditor's claims, the claims may be satisfied out of the debtor's other property on an equal basis with other unsecured creditors in the same rank of priority.
Provision of Loans to Russian Borrowers
As loans compose the bulk of the financing for the project company, lenders should be aware of the restrictions which Russian currency regulations impose with respect to providing loans to Russian borrowers.
The general rule is that loans provided by non-residents to a Russian borrower for more than 180 days require approval from the Central Bank of Russia (CBR). Obtaining this approval may be a time-consuming process. If a financing facility requires that a guarantee agreement must be executed between the Russian borrower and a non-resident guarantor, a separate licence from the CBR must be obtained to enable the guarantor to provide funds pursuant to the guarantee agreement. Although sometimes an onerous process, if substantive lenders and borrowers are committed to a project, the CBR will eventually grant its permission.
The principal document which must be submitted to the CBR to secure its approval for the loan is the loan agreement. Russian regulations are sometimes interpreted as requiring that an application for a licence from the CBR with respect to the disbursement of a loan be rejected if the loan agreement is not governed by Russian law, which may raise an issue for lenders who would prefer a foreign governing law. This problem often arises when dealing with territorial branches of the CBR. The CBR's main department will usually approve a loan even if the loan agreement is governed by a foreign law. Given the size of the loans involved in financing a project and the value of the security, lenders should opt for a foreign governing law on the assumption that approvals for their project will be obtained from the CBR's main department.
All currency transactions to be carried out under a loan agreement must be channelled through a single currency account of the borrower with a single authorized Russian bank. If the lenders do not wish to provide a loan through a Russian bank, then the Russian borrower must obtain the CBR's permission to open an account with a bank outside of Russia, but there will still need to be a Russian bank to act as an agent of currency control. However, it is possible for Western banks with Russian subsidiaries to act as agents of currency control.
Governing Law of the Project Agreements
The remaining project agreements - including, for example, the construction contract, operating agreement and supply contracts - should generally be governed by a law other than Russian law. In addition, the parties to these agreements may select a forum for arbitration outside of Russia and an arbitration procedure governed by an internationally recognized set of rules, so that the parties (especially foreign parties) will have access to as neutral a dispute resolution forum as possible.
Project financing is traditionally associated with the types of businesses that require approvals or licences from various government authorities. In Russia, such approvals and licences are often effective only for a specific period of time, which may be shorter than the term of the project. Thus, a potential risk exists that the licences may not be renewed. It is also the case that the development of certain types of projects (eg, mining) requires licences which are issued on the basis of tender or auction processes.
Environmental Protection Matters
Another issue of great sensitivity to lenders and project sponsors is environmental liability. Russian environmental authorities have broad authority in monitoring the ongoing regulatory compliance of a project. In case of a violation of these requirements, they may suspend or even terminate the project, although this is rare (more often they will impose penalties). Although the enforceability of environmental protection requirements in Russia remains underdeveloped, in certain cases environmental standards may be much stricter than those typically found in other parts of the world. In addition, projects financed wholly or largely through foreign investment will usually attract more attention from government authorities, including environmental protection authorities. This may mean that the development of the project will need to be carried out in strict compliance with all environmental regulations, as well as any other requirements imposed but not otherwise specifically provided for by law. Lenders and sponsors of a project should also be aware that the project company may be asked to assume liability for pre-existing environmental conditions at a project site as a condition for receipt of relevant environmental approvals, although such requests have been rare.
In structuring, negotiating and documenting a cross-border project financing, the lenders and sponsors must take into account the currency risks associated with the non-convertibility of the rouble and the various restrictions on convertible currency transactions.
The requirement of mandatory conversion of convertible currency proceeds remains one of the most problematic issues for foreign investors in Russia. Since the early 1990s, Russian law has required compulsory conversion of convertible currency proceeds received from the export of goods from Russia. Thus, if the goal of the project developers is to generate revenues from the sale of products abroad (including fuel and energy), the lenders and equity investors should factor the conversion requirements into the costs of a project. Generally, under existing Russian law, 75% of convertible currency earnings must be sold on the internal Russian currency market within seven days of receipt thereof, although funds disbursed pursuant to loan agreements are not subject to mandatory conversion.
While it is possible to obtain an exemption from the currency conversion requirements, an exemption may only be obtained by the passage of a federal law or the issuance of a decree by the Russian president.
Non-convertibility and devaluation of currency
Under Russian law, legal entities may only convert roubles into convertible currency in certain situations. A CBR licence issued with respect to a loan will ordinarily allow the Russian borrower to purchase convertible currency in order to make payments under the loan agreement. However, the Russian borrower will not be allowed to purchase convertible currency on an ongoing basis to accumulate such amounts as may be necessary to meet a future repayment date.
Additionally, there is always the risk that the rouble earnings of a project may depreciate in value before they can be exchanged for convertible currency to service the debt owed to foreign lenders. To mitigate the currency exchange risk, the repayment schedule should be linked to the projections of cash flow expected to be generated by the project. Care must be taken to ensure that the provisions of the CBR licence allow for such a repayment structure.
Repatriation of profits
For equity investors in a project, the main concern is to ensure repatriation of profits generated from the project. There are various methods by which foreign investors may repatriate profits earned on their investments in Russian companies. These should help them to guard against the rouble currency risk. Often parties will attempt to repatriate profits through declaration of a dividend out of the project company's net profit with no restrictions on convertibility, which does not require a specific approval from the CBR. However, there may be taxes payable in this case by the project company. In addition, the repatriated profits may be subject to Russian withholding tax unless otherwise provided in an applicable double taxation treaty.
Additionally, foreign investors often use various types of services agreements, including marketing or management agreements, as a vehicle to repatriate profits. However, the CBR recently adopted a new regulation which requires that permission must be sought from the Federal Foreign Exchange and Export Commission every time a payment for services in excess of $10,000 is to be made to a non-resident. The services agreement may thus be administratively burdensome in practice, so its usefulness as a mechanism to repatriate profits may be limited. As a general rule, services rendered and consumed on the territory of the Russian Federation are subject to value added tax.
Political Risk Insurance
The risk of significant shifts in the political and legal environment remains a significant barrier to the development of projects in Russia. Lenders may require that the risks of, for example, devaluation of currency, expropriation of property and political upheaval be shifted to political risk insurers, such as the Overseas Private Investment Corporation or the Multilateral Investment Guarantee Agency.
In an effort to develop the Russian project finance market, the Russian government has established a special organization, the Federal Centre for Project Finance (FCPF), to deal with financing provided to Russia by multilateral and international institutions. One of the most ambitious projects which the FCPF has undertaken is the structuring of a system of political risk insurance in the regions of Russia. Financed by the World Bank, the first such project of the FCPF is aimed at establishing a system of political risk insurance in favour of projects related to the development of the timber and coal sectors in certain Russian regions. The programme will provide guarantees for these projects in order to protect against losses incurred as a result of actions taken by federal and regional authorities. Although the programme will only affect projects in the coal and timber industries, and is limited in its geographic scope, it gives some assurance to foreign investors and financing institutions that their rights will not be violated. Further, if their rights are violated, they will at least have the right to seek compensation for their damages. If this system is successful, there is a chance that it will be expanded to cover other regions and industries in Russia.
Project financing in Russia does not have a long history and therefore, developing projects in Russia will likely raise issues not previously addressed by Russian regulators. This Overview outlines only certain issues of concern related to financing agreements which lenders and sponsors of project financing in Russia may encounter. Obviously, different types of projects will raise specific issues which will need to be carefully examined prior to commencement.
For further information on this topic please contact Laura Brank at Chadbourne & Parke by telephone (+7 095 974 2424) or by fax (+7 095 974 2425) or by e-mail ([email protected]).
(1) However, lenders often require that equity interests be pledged to secure the debt as well, so that the lender may choose to exercise its remedies directly against the project assets or by seizing a controlling equity interest over the entire project.
(2) However, once bankruptcy proceedings are commenced against a pledgor, the pledged property will be included in the bankruptcy estate.
(3) In contrast to decisions of foreign arbitration tribunals, which are enforceable in Russia by virtue of the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards and the Russian Federation Law on International Commercial Arbitration, Western court awards are generally not enforceable in Russia.
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