Lexology GTDT Market Intelligence provides a unique perspective on evolving legal and regulatory landscapes. This interview is taken from the Project Finance volume discussing topics including PPP, risk allocation and notable deals within key jurisdictions worldwide.
GTDT: What have been the trends over the past year or so in terms of deal activity in the project finance sector in your jurisdiction?
Ricardo E Vieira Coelho: Our firm has multidisciplinary teams involving the best in each specialisation and working in our project finance practice. We have been involved in almost every major project finance transaction over the years, especially considering those transactions sponsored by government-controlled companies. Project finance transactions have been very attractive for the government, because they could be structured in a manner to enjoy off-budget treatment, mitigating certain public budgetary constraints.
Besides most oil and gas projects (Espadarte/Voador/Marimbás, Barracuda, Cabiúnas and Malhas (Southeast/Northeast), to name a few), we have also been involved in airport infrastructure — concessions for the operation, construction and operation of airports at the federal government level (for instance, Guarulhos), as well as in sewage projects at municipal level. Depending on the nature of the project, different legislation may apply to the specific case at municipal, state or federal levels.
There are also projects in the transportation sector (for instance, subway, municipal trams and toll roads) and maritime transportation (including construction and operation of several floating production storage and offloading and other vessels), as well as major hydropower plants (such as Jirau, Santo Antonio and Belo Monte) and renewable energy projects (more particularly, wind power projects).
More than a decade ago, we worked together with the government and other players in the market to assist in the preparation of a bill of federal law to regulate public–private partnerships (PPPs) at the federal level. The federal law was issued but so far there have only been a few transactions at the federal level, although state and municipal legislation using the federal law as a template have made feasible the implementation of several local PPP transactions.
GTDT: In terms of project finance transactions, which industry sectors have been the most active and what have been the most significant deals to close in your jurisdiction?
RC: The federal government recently created the Investment Partnership Programme, which purports to increase and strengthen the participation of the private sector in infrastructure projects, by means of public–private partnerships and privatisation. Infrastructure projects considered of national priority by public authorities include, among others:
- oil and gas bidding rounds;
- divestments of mixed capital companies in energy sector (generation and distribution of electric energy);
- mining assets;
- airports; and
Several measures have been adopted by government authorities to heat up the oil and gas industry in Brazil. To such effect, the Brazilian Petroleum, Natural Gas and Biofuels Agency has already scheduled several bids for the coming years to make the bidding rounds more predictable (in 2018, the 15th Bidding Round (May), the 4th Production Sharing Bidding Round – Pre-Salt (May) and the 5th Marginal Fields Bidding Round (yet to be defined); in 2019, the 16th Bidding Round (3rd Quarter), the 5th Production Sharing Bidding Round – Pre Salt (3rd Quarter) and the 6th Marginal Fields Bidding Round (to be defined). The Brazilian local contents requirement policy is also currently undergoing intense debate by multiple public authorities and a specific regulation on the matter is expected to be enacted in the near future. The Brazilian federal tax authorities have also recently issued a new regulation for the tax treatment of exploration, development and production of oil and natural gas activities, and established a calculation formula for the purpose of withholding income tax applicable to cross-border charter or lease contracts of vessels operating in Brazil, subject to contractual split (whenever there is charter with rendering of services). Such new regulation is expected to enhance the legal certainty for investors of the oil and gas industry.
In 2017, the Ministry of Mines and Energy launched a public consultation on changes to the electricity regulations, aiming at improving the legal framework and also to reduce the litigations involving agents of the electric power sector. The federal government also announced the privatisation of Centrais Elétricas Brasileiras SA (Eletrobrás), a listed company controlled by the Brazilian government with presence throughout the entire electric chain (generation, transmission and distribution) and the largest company in the electricity sector in Latin America.
There is ongoing controversy with respect to the validity of a foreign vessel mortgage in Brazil. A recent decision rendered by a higher court acknowledging the validity of the foreign mortgage based on international treaties, although still subject to appeal, is likely to consolidate the validity of foreign mortgages in Brazil, enhancing a standard ship financing practice widely adopted in the international market and providing additional comfort to financiers and suppliers in Brazilian operations.
New rules have extended the duration of authorisations to operate port facilities in Brazil from 25 to 35 years, which may now be extended for successive periods for up to 70 years. The management of public ports may also negotiate the anticipation of tariff revenue with users, in order to invest in infrastructure.
GTDT: Which project sponsors have been most active in driving activity? Which banks have been most active in providing debt finance?
RC: Project finance transactions generally involve several stakeholders, such as creditors, suppliers, financiers, liquidity providers, insurers, regulatory agencies or granting authorities, in the particular case of projects subject to a concession, authorisation or permission regimen.
In recent decades, BNDES, the Brazilian development bank, has been the major provider of long-term finance in Brazil. Commercial banks in the private sector usually follow BNDES, especially on-lending funds from BNDES and by way of infrastructure debentures (a type of project bond with tax incentives), as well as other foreign export credit or multilateral agencies, to provide financing in a shorter term, so that they can be repaid first and exit from the deal. In specific regions, we have also verified the participation of regional development banks and governmental agencies, such as BNB (Northeast development bank) and SUDENE (Northeast development agency). Other than in such circumstances, it may be difficult to obtain long-term finance from private banks in Brazil. So far BNDES has led this source of long-term financing for project finance in Brazil. The number of applications for BNDES financing, however, has reduced dramatically in recent years, driven by government deficits and corruption scandals involving government-controlled companies that have reduced, if not paralysed, the negotiation of many projects of such nature. The recent change in the methodology to calculate the interest rate charged by BNDES is expected to make the private sector more competitive as far as long-term financing in the local market is concerned.
Joint venture arrangements also related to project finance transactions shall be subject to antitrust clearance whenever the transaction could have a direct or indirect impact in Brazil based on the parameters set forth by applicable law, and must be previously submitted to CADE (the Brazilian antitrust authority) for approval.
To such effect, the concept of economic group for the purposes of the Brazilian Competition Law is very broad.
“Under Brazilian law, contracts shall be subject to the existing legislation, that is, they must comply with the legal provisions applicable to the transaction as well as be subject to the specific limitations or restrictions established by virtue of law.”
GTDT: What are the biggest challenges that your clients face when implementing projects in your jurisdiction?
RC: The basic element to be considered derives from the fact that project finance transactions were conceived in jurisdictions governed by common law, rather than by civil law (as in Brazil). Under Brazilian law, contracts shall be subject to the existing legislation, that is, they must comply with the legal provisions applicable to the transaction as well as be subject to the specific limitations or restrictions established by virtue of law.
In Brazil, it is not customary to have a true project finance, ‘plain vanilla’ project, when the project cost is fully repaid by project revenues, either because the creditors could generally resort to the debtor, or the sponsor/project assets (including also receivables) could be affected by labour, social security or environmental liability, for instance, depending on the nature and structure of the project. For such reason, it is necessary to structure the project carefully, whereby the project assets are ring-fenced and protected from third parties as much as possible. In many project finance deals there is a type of corporate finance or asset-based finance, where a suitable security package would also play an important role in mitigating creditors’ exposure to risk, besides requiring appropriate insurance to cover customary project risks in connection with the completion and operation of the project.
Corporate governance of local legal entities, including consortium arrangements and shareholders’ agreements, must be governed by Brazilian law.
It is essential therefore to understand the specific features of Brazilian law to negotiate a local joint venture, implement the mechanics for local tariff calculation and adjustment and to enforce the security package.
In the energy sector more specifically, there is typically a mismatch between the tariff that is linked to the Brazilian currency (the real) and adjusted for inflation, on the one hand, and the project cost variation when involving foreign financing, on the other. For power purchase agreement with independent power producers, the developers may sell to the sponsor and recover the investment through that type of sale. To deal with currency mismatch issues and enjoy certain tax benefits, many transactions have resorted to the issuance of debentures (which is a type of debt security that may be adjusted according to foreign exchange variation) in the local market and that has also been an interesting source of finance for this type of transaction.
The same situation may occur in the event of a project finance implemented with foreign funds and generating local revenues paid in Brazilian currency and adjusted for inflation (rather than by foreign currency variation). There are mechanisms, however, that have been successfully adopted to mitigate such type of risk.
There is no discussion about the appetite for sewage projects in Brazil, although there has been a debate as to who shall provide financing support to such projects. For projects sponsored by state governments, there is also a regulatory risk involving the possibility of municipal governments to start providing such services in a portion of the same geographical area, impacting the generation of project revenues.
In case of airport deals, for instance, the bids were made taking into account the project revenue forecast. The possibility that the government might authorise the construction and operation of new airports in the neighbourhood of the existing airport must be discouraged to avoid any adverse flow of passengers and cargo at the existing airports and, consequently, any reduction in expected project revenues.
“ Key assets are being sold to generate additional income for the government at federal, state and municipal levels.”
GTDT: Are there any proposed legal or regulatory changes that may give rise to new opportunities in project development and finance? Do you believe these changes will open the market up to a broader range of participants?
RC: There are several ongoing regulatory discussions purporting to address specific market concerns or to promote broader reforms in many different sectors.
As a result of the opening of specific segments, which were being maintained as monopolies operated by government-controlled companies, discussions on the new regulatory regimen are defining the legal framework for operation by private sector entities. Certain dysfunctions in specific sectors (such as local content requirements in the oil and gas and the generating scale factor in the energy sector), which resulted in an increase of lawsuits in such sectors, may have also brought about such discussion to adapt their rules to the current economic scenario. In the case of PPPs, a company in the private sector may carry out certain activities for the government and in turn be repaid through receivables from the project, which may be enhanced by government contributions as a shadow toll either partially or totally, depending on the nature of the project.
New projects are also expected to be developed as a result of a new regulatory model under discussion for natural gas, which may also enable the acquisition, modernisation, construction, expansion, operation and financing of new plants and transportation pipelines.
Compliance and corporate ethics, as well as financial soundness in the medium and long term, are key aspects to be considered to negotiate appropriate indemnification provisions and avoid liability disputes in the future.
GTDT: What trends have you been seeing in terms of range of project participants? What factors have influenced negotiations on commercial terms and risk allocation? Are there any particularly innovative features?
RC: While corporate finance involves debt (credit analysis based on past performance), project finance transactions involve risks (both commercial and political). The sponsor may not have a good credit rating, but reliance on project feasibility may be a keen factor in attracting investors and for successful implementation of the deal. Indebtedness requires guarantees, while risks require insurance. The increase in project finance transactions is expected to develop the insurance market even more, and thus the methods of covering risk in Brazil.
There are also cases in which the financiers require that shareholders or sponsors meet certain minimum investment level requirements, including without limitation by providing parent guarantees to show their commitment to the project.
GTDT: What are the major changes in activity levels or new trends you anticipate over the next year or so?
RC: As is generally known, Brazil is the world’s fifth largest country (and the largest in South America) by geographical area, divided into 26 states and one Federal District (Brasília), with its territory spanning three time zones and a population of more than 200 million people. The country has also increasingly been expanding its presence in international financial markets, and is also part of the BRICS country group. Brazil has by far the largest economy in Latin America.
Project finance transactions appear to have been affected by an ongoing economic, political and fiscal crisis after a long period of economic growth in Brazil. On the other hand, key assets are being sold to generate additional income for the government at federal, state and municipal levels. There has been an increase in major M&A transactions as a result of such divestment programmes carried out by government-controlled companies – including Petrobras corporate group, the major Brazilian oil company – as well as a result of financing and corporate restructuring of major Brazilian entities, as well as by companies involved in corruption scandals or otherwise in need of ready cash to settle debt obligations or targeting selected investments more focused on their core business.
The forecast for 2018 onwards is more optimistic, as the market is expecting a scenario of a controlled inflation rate, social security reform and more control of public expenditure. A better defined political environment is also expected as a result of the election of a new President of the Republic, members of Congress, state governors and state representatives. The preparation and follow-up on the ongoing discussions about regulatory matters may give leverage to potential investors and financiers.
Infrastructure facilities, agribusiness, biofuels, mining, construction, transportation, roads and even railroads, sewage, port operations and especially energy-related projects, including renewables such as solar power plants and wind farm projects, are expected to increase.
Eletrobrás is likely to be privatised, according to a bill of law proposed by the President of Brazil and currently under discussion by Congress. Even if the privatisation of Eletrobrás itself takes a while, the sale of specific companies (including power distribution concessionaires) is expected to take place swiftly.
A rise in oil prices on the international market and the new auctions set up to exploit oil fields in Brazil, including those in the pre-salt area, are likely to attract new projects for the shipbuilding industry and the oil and gas sector supply chain.
PPPs in the health and education sectors would be welcome. As was the case of a leading project carried out by the state of Minas Gerais, investment in the construction, expansion and modernisation of federal prisons may also come to the fore.
The government has been facing budgetary deficits and, notwithstanding the continuous strengthening of capital markets in Brazil, the funds available in the local market may not suffice to cover the needs of infrastructure satisfactorily. The implementation of project finance deals would be a competitive way to finance transactions that can be posted off budget and make feasible the expansion and enhancement of infrastructure, particularly in view of the public budgetary constraints and the anticipated recovery of the Brazilian economy. There is a solid regulatory framework in place that has reduced the concerns of foreign players and needs to be properly understood to make a better risk assessment.
The Inside Track
What three things should a client consider when choosing counsel for a complex project financing?
Reliance, expertise and deal maker. The selected firm should also have experienced attorneys in a sufficient number and able to act in a harmonious and robust working team.
What are the most important factors for a client to consider and address to successfully implement a project in your country?
To better understand the peculiarities of each jurisdiction, in order to make a proper risk assessment for the project and accommodate the different interests of multiple players.
What was the most noteworthy deal that you have worked on recently and what features were of key interest?
The Malhas project was an interesting experience, not only considering the challenges faced in negotiating and developing a leading project related to natural gas transportation pipelines in the absence of detailed regulations applicable to the case at that time, but also because later on we were able to assist the company during the operational phase and exit from the project. More recently, we also participated in the sale of the project company to a third-party buyer in different circumstances and where a regulatory framework is already in place and ongoing. Another interesting project was the financing of a municipal tram (light rail vehicle) with BNDES support in public-private partnership, sponsored by the municipality of Rio de Janeiro and destined to enhance transportation in preparation for the 2016 Olympic Games in Rio.