This article is an extract from The Project Finance Law Review - Edition 3. Click here for the full guide.

I Introduction: contractual risks in project finance

One of the most important factors in successfully closing project finance is the process of structuring and assigning risks before, or in parallel with, the drafting of the financial documentation, a process known as due diligence. During this process, the various risks to be assumed by the special purpose vehicle (SPV) that will run the project are identified and analysed by the banks' advisers, allowing them to be properly assessed, mitigated and assigned to the party best placed to assume them. The purpose is to preserve the assumptions of the financial model agreed upon by the client and the banks, which in turn is intended to provide an adequate long-term projection of the income and expenses of the project.

Many of the key assumptions on which the financial model is based are related to the construction stage of the project and tend to be the follows:

  1. the need for fixed construction costs;
  2. the need to identify and limit the SPV's liabilities during the construction stage, beyond the construction costs;
  3. the requirement for a fixed start date for the project's commercial operations; and
  4. the need to confirm the project's capacity to generate the projected income during the commercial operation stage by verifying that the actual construction meets the specifications initially agreed upon.

The assessment of these risks involves a detailed technical, insurance and legal analysis of the contract or contracts to be entered into by the SPV in order to carry out the construction of the project (the Construction Contracts). The purpose of this due diligence is to determine the scope and quality of the SPV's rights and obligations during the construction stage and immediately following the project's completion, when the construction is still under guarantee.

In this chapter, we focus on the legal and contractual aspects of due diligence regulated in Construction Contracts.

We like to say that this is a 'layered' analysis, in which we take a three-pronged approach to the review of the contractual documentation to which we have access. First, we work to understand the scope of the SPV's rights under the Construction Contracts and whether these rights adequately assign, to the counterparties to the Construction Contracts, the risk pertaining to the liabilities assumed by the SPV under the main agreements that make up the source of its income, or the liabilities arising from the regulatory framework surrounding those agreements, or simply the income expectations deriving from the assumptions included in the financial model. Second, we seek to ensure that the SPV's rights and obligations under the Construction Contracts are in line with the best market standards for the type of project. Third, we verify that the Construction Contracts do not contain any defective wording that would jeopardise the enforceability of the rights granted to the SPV thereunder.

II Primary risks associated with the construction stage

i Cost overruns

The risk of the construction ultimately costing more than the available funds from the sum of the senior financing, the mezzanine financing, if any, and the equity provided by the developers is the most material risk for the lenders in project finance.

This is why one of the main efforts during the due diligence process goes towards identifying scenarios under the Construction Contracts that could give rise to payment obligations for the SPV beyond the payment of the initial amount agreed as the price of the works.

While in an ideal world we would seek to have the counterparties to the Construction Contracts absorb any risk of cost overruns, we cannot avoid the fact that market standards dictate that contractors have the right to claim for increases in the contract price in certain scenarios, such as:

  1. non-fulfilment by the SPV or by other contractors of the SPV;
  2. changes in the regulations subsequent to the signing of the Construction Contracts that require that they be amended;
  3. alterations to the project imposed by a third party with the power to do so (i.e., the grantor or the offtaker under their respective agreements); and
  4. archaeological finds, discovery of hazardous substances at the construction site.

In all these cases, the counterparties to the Construction Contracts are unlikely to assume the risk of cost overruns, since in each case the circumstances are beyond the contractor's control.

Consequently, the work of due diligence consists of ensuring that the rights of the counterparties to the Construction Contracts to claim for cost overruns are properly defined and limited, to ensure that there can be no abuses in their exercise. Furthermore, the financial documentation must provide supplementary resources, whether through the sponsors or by making other contingent lines of credit available, to cover such cost overruns if they occur.

In other cases, however, the risk of cost overruns comes up in situations that are avoidable. This is where the counterparties to the Construction Contracts seek to take advantage of deficient contractual wording or inadequate assignment of the risks, in order to transfer the risk of cost overruns to the SPV.

The following are some typical examples of cost overrun causes:

  1. there being no single agreement that encompasses all the services necessary for the project's construction. This risk is usually mitigated by having the various counterparties to the Construction Contracts enter into interface agreements, which oblige them to acknowledge the coexistence of their services and coordinate the provision thereof to avoid delays or cost overruns;
  2. force majeure. We will return to this point later on, but suffice it to say here that many counterparties to Construction Contracts seek compensation from the SPV for losses or cost overruns that result from a force majeure event. Counterparties should bear in mind that the SPV is not an insurance company, and that they can always take out their own insurance; and
  3. deficient regulation (or worse, deficient contractual wording) of the liability of the counterparties to the Construction Contracts for matters such as the condition of the construction site, claims from subcontractors, contractor permit or licensing costs and guarantee costs.

All such risks should be identified during the due diligence process and, if possible, remedied, as a condition for the financing to be paid out.

ii Delay in completion

One of the characteristics of EPC contracts is that the contractor undertakes to build certain infrastructure for a fixed price and with a set and measurable deadline, which is usually set out in a timeline attached to the contract. This timeline comprises a series of milestones that allow the project developer and the lenders to monitor the degree of completion of the work.

As we can see, timing plays a key role in analysing the bankability of Construction Contracts. This is because both developers and lenders create the financial model based on the date (i.e., scheduled commercial operation date/scheduled project completion date) after which the project will be capable of generating sufficient cash flows to – in this order – defray the project's operational costs, service the senior debt, and provide returns on the equity contributed by the developers. It is for this reason that all Construction Contracts include delay liquidated damages clauses that must be sufficient to cover, for a certain period of time, at least any initial payment commitments under other project documents (e.g., delay liquidated damages under the PPA or payments under fuel purchase agreements) and the above-mentioned debt servicing.

These delay liquidated damages are usually calculated as a fixed amount for each day of delay past the scheduled COD and are usually limited to a percentage of the total price of the contract. After that limit has been reached, the contractor/owner is usually entitled to terminate the contract.

However, in many cases, delay-liquidated damages and the termination mechanism described above are not sufficient to mitigate the risk of delay, due to the resistance of counterparties to the Construction Contracts to accepting penalties for missing intermediate milestones. The result is that when the delay occurs that allows the SPV to try to replace the contractor in breach, it is too late.

Consequently, it is important to have mechanisms in place to guarantee the SPV's right to replace a delayed contractor before delay-liquidated damage starts to accrue. Something that is very useful for this are clauses that require contractors to present a recovery plan whenever a material delay is confirmed in the initially envisaged work timeline that affects or undermines the critical path. The non-fulfilment by the contractor of its obligation to present the recovery plan, or of the recovery plan itself, should empower the SPV to terminate the contract affected by the delay without waiting for penalties for delay to start to accrue.

In addition, a well-designed payment schedule with a sufficiently broad final payment tied to the start-up of the commercial operation of the infrastructure creates sufficient incentive for the contractor to complete its work on time. To be effective, this payment should be large enough that the profitability of the contractor's work is jeopardised if it does not receive the payment.

Lastly, it is highly advisable for the Construction Contracts to include precise provisions setting forth an exhaustive list of the scenarios that will entitle the contractor to request deadline extensions. These provisions should have various aims: (1) to ensure that the SPV can effectively verify the causal relationship between the event creating the delay and the actual delay (to this end, the period in which the contractor may invoke the delay after the event causing it has occurred should be limited); (2) to clearly establish the formula for determining the deadline extension, to the extent possible, in order to avoid disputes; and (3) to take a formalistic approach, such that the right to a deadline extension is only effective as from the date on which the related agreement amendment order is entered into by the SPV and the contractor.

iii Performance guarantees

Another one of the main risks to consider is that of the need to preserve suitable rights for the SPV in the event that what is constructed is not as agreed, either because the approved technical specifications have not been followed or because the construction is incapable of performing at the levels agreed by the parties.

In addition to the rights of the SPV referred to above, Construction Contracts must also include specific protection for the SPV in the event that the construction is unable to achieve the performance expected in the financial model. This is because even if the project fails to perform at the levels guaranteed by the counterparty to the Construction Contract, the SPV will remain bound to its obligations under the financial documents; these obligations will not be downgraded as a result of the construction's inability to attain the levels of performance expected.

Apart from the consequences of the diminished income stream deriving from this underperformance, it is also important to note the potential consequences arising in relation to agreements entered into by the SPV with third parties where the construction is unable to achieve the desired performance, either in the form of monetary liabilities for the SPV or even leading to these contracts' early termination. Construction Contracts should, to the extent possible, include a penalty system in which the penalties serve the following objectives:

  1. to re-establish – and be sufficient to fund – the assumptions set out in the financial model that are jeopardised because of the failure to perform under the Construction Contract;
  2. to provide the SPV with access to the necessary liquidity quickly, right from the time the failure to perform occurs, so that the situation can be reverted before the funding collapses; and
  3. to dissuade the parties from the tactical convenience of filing suit, which could delay resolving the problem for both the project and the SPV, so they should be drafted in very precise terms.

The manner in which the objectives described should be expressed for each project will vary depending on its type, the technology and the consequences that the construction's failure to perform as agreed have on the undertakings made by the SPV to third parties and the assumptions included in the financial model.

iv Force majeure

The regulation of force majeure is always relevant when analysing whether Construction Contracts meet bankability criteria.

When analysing Construction Contracts in relation to force majeure, we apply the layer technique as described in the introduction to this chapter. In other words, the following must be confirmed.

First, that the contractor's rights in a force majeure scenario are no different from those of the SPV under the main agreements that will constitute the source of its income. When faced with the same fact or circumstance, these rights cannot differ, without that circumstance creating a bankability problem that must be remedied in the financial documents, entitling the sponsor to lodge the corresponding appeal to cover this lack of coherence between the different agreements signed by the SPV. This is what is known as the back-to-back principle we mention so often when describing the analyses of a due diligence.

Second, that our analysis considers the issues that are relevant to the type of project being analysed, as well as the specific connotations of the site where the works are carried out, to ensure that the definition of force majeure and the rights and obligations of the SPV under the Construction Contracts in light of a case of force majeure correspond to the highest market standards for these types of works. To give some examples: the fact that the worksite has been flooded should not be considered an event of force majeure, if the parties are aware that the land is prone to flooding or indeed frequently suffers flooding; and event of force majeure cannot be defined in the same way when dealing with the construction of a motorway as opposed to other types of infrastructure that imply working at heights, such as the construction of a wind farm.

Third, when regulating force majeure, that Construction Contracts contain no defects that could jeopardise the enforceability of the rights granted to the SPV under such contracts. This idea is related to the concepts set out in the section on delays and the regulation of contractors' entitlements in these situations, which would serve as a basis for requesting an extension of the deadline.

Lastly, the covid-19 pandemic caused by a coronavirus has put to the test the regulations on force majeure in most construction contracts, giving rise to many queries in relation to both contracts already signed, as well as those under negotiation. At this time, from the standpoint of bankability and the sponsor, the restrictions or limitations caused by covid-19 or any of its mutations should be expressly excluded from the definition of force majeure, claiming that it is now a foreseeable event. It may be necessary, however, to introduce an ad hoc scenario to regulate the consequences of construction works having to be suspended as a result of covid-19-related restrictions. In this regard, our experience tells us that it will be possible to reach an agreement under the Construction Contracts if the parties find a suitable way to share this burden. Indeed, the financial model will also have to include provisions in anticipation of possible adverse effects due to this circumstance, because if these provisions are not made, it would be the sponsors who are liable for any consequences not assumed by the counterparties under the Construction Contracts, in an effort to once again ensure that the assumptions set out in the financial model are intact.

v Expertise, reputation and creditworthiness of contractors

The main contractor's expertise and reputation help to ensure that the project is executed and completed on time and at the price agreed; these are factors that lenders should assess when analysing a project's bankability.

The risk, therefore, will lie in a contractor being unable to meet its contractual obligations, both technical and financial, by failing to dedicate sufficient human resources to the project, by not having the appropriate technical qualifications or by lacking the financial resources.

This risk must be mitigated at a very early stage of the project when it is being structured. Lenders can request, if they feel that a contractor does not have the minimum required levels of expertise, reputation or creditworthiness, a credit enhancement in the form of a letter of credit or corporate guarantee from the contractor's parent company, to ensure the project's viability.

The main issues in relation to the risks entailed in letters of credit and corporate guarantees are as follows.

Regarding letters of credit that secure the payment obligations of the counterparties to Construction Contracts, close attention should be paid to the following:

  1. the wording. It must clearly state that the SPV can access the available liquidity, without needing to demonstrate to the bank that the contractor has committed a breach;
  2. the possibility of the SPV's rights being exercised by the banks. This is particularly relevant when the SPV and the contractor belong to the same corporate group, when faced with the risk represented by a conflict of interest; and
  3. the regulation of the SPV's rights in light of the upcoming expiry of the letters of credit. It is important that the Construction Contracts include a provision permitting the SPV to enforce letters of credit even if the contractor has committed no breach, if there is a risk of the letter of credit expiring and not being renewed by the contractor. In that case, the SPV would be entitled to withhold the amounts obtained by enforcing the letter of credit, in the form of a liquid guarantee as an alternative to such letter of credit.

Regarding corporate guarantees, the potential issues have to do with their function. There are corporate guarantees that only serve to position the guarantor company on the same level as the contractor company under the corresponding Construction Contract. In this case, the due diligence analysis should confirm that the SPV has the same rights vis-à-vis the guarantor as vis-à-vis the principal obligor under the Construction Contract. Other corporate guarantees, however, serve to replace the letters of credit from banks. In this case, the due diligence should confirm that the SPV will be able to claim against the guarantor just as it would against a bank, if it had a letter of credit. In this regard, the analysis should cover the same aspects as those mentioned for letters of credit.

vi Main contractor's relationship with its subcontractors

Another matter that attracts great attention when carrying out due diligence is the relationship the main contractor has with its subcontractors. While in the past this analysis mainly focused on confirming that the SPV has no liability towards the main contractor's subcontractors but that the contractor is liable, without exceptions, for all construction projects executed by its subcontractors, this analysis focuses more recently, in addition to the foregoing, on the need to establish mechanisms that permit the SPV to confirm that the contractor (1) is meeting its obligations to its subcontractors; and (2) is not using its subcontractors to finance itself. The reason for this new angle of analysis lies in notorious precedents in the sector where, after the main contractor had become insolvent, it was discovered that the contractor had also diverted funds from the financing that should have been used to pay its subcontractors, resulting in the project not only having to face the difficulty of replacing an insolvent contractor, but also having to overcome the practical difficulties arising from a cohort of unpaid subcontractors whose collaboration is often essential in order to be able to resume the works.

In order to mitigate this risk, Construction Contracts should include mechanisms that (1) remove the main contractor's discretionary powers to set payment terms with its subcontractors and (2) enable the SPV to monitor to what extent the main contractor is meeting its payment obligations to its subcontractors (including, for example, making it necessary for the contractor to demonstrate that there are no unpaid amounts owing to its subcontractors) as a prerequisite for having its own invoices paid.

vii Dispute resolution mechanisms

Certain issues regarding risks to the parties' rights, when potential disputes arise during a project's construction, merit special mention here.

In terms of bankability, one very obvious issue concerns how the parties could become engaged in a dispute surrounding a question of fact or the interpretation of a provision of the contract during the execution of the works. This can become a major contingency if the Construction Contracts do not contain appropriate mechanisms to mitigate the risks from the consequences of the dispute on achieving the goals contained in the financial model.

Thus, Construction Contracts should ideally contain:

  1. dispute resolution mechanisms that are streamlined and efficient and that dissuade the parties from the tactical convenience of filing suit;
  2. clauses that oblige the parties, and particularly the contractor, to continue to execute the works even if a dispute arises that is pending to be resolved;
  3. clauses that permit the SPV to exercise its contractual remedies against the contractor, even when the dispute is pending resolution, in order to prevent the contractor from asserting that the SPV is constrained by the time restrictions on its financial obligations and to third parties, so as to impose upon it conduct or an agreement that is contrary to its interests (and, therefore, contrary to those of the banks as well); and
  4. dispute resolution mechanisms that are coordinated with the different contractors, if more than one, and their corresponding guarantors, so as to avoid the situation where a dispute or claim brought by the SPV needs several legal proceedings in order to end successfully, as that would be tantamount to not having established a suitable contractual framework.

III Conclusion

This chapter is our description of the fundamental aspects to consider when analysing the suitability of a contractual structure with which to correctly assign the risks of the construction stage of a project, so as to enable the project to be financed. While there are many other risks that we could also mention and although we could elaborate further on those raised here, as this topic lends itself to much more discussion than allowed by the size constraints of this chapter, we do hope that our readers will find this information useful and clear.