Owing to flooding of foreign investments in key sectors like infrastructure, township development and natural resources, project financing in India has shown immense growth. The law governing project financing is not a ‘readymade’ set of laws; rather it is a mechanism designed prospectively to carry out projects at a large scale, considering the complexity and costs. Despite the regulatory shortcomings, project financing has evolved in India as non-recourse financing or at the most, a limited recourse financing, which depends completely on the merits of a project rather than the credit of the project sponsor. All project financings have more or less similar elements, i.e., debt from banks or government lenders, or subordinate loan from project sponsors. At the same time, collateral security is also present in the form of assignments of contractual rights to support the underlying debt obligations. As the project itself forms the key determinant of the financing, it is only fair to expect the projects to be time-consuming, especially when these projects generally involve sectors like energy, infrastructure and natural resources.
Traditionally, in any infrastructure project, especially a large one, the prime source of finance has been Commercial Banks. These banks finance the project looking at the creditworthiness of the project and require a first security over the infrastructure created or the project assets. However, such loans are expensive and banks are fast approaching their lending limits. The overall capitalization for public sector banks is also acting as a constraint for the commercial banks to increase their infrastructure financing portfolio. In India, the infrastructure focused Public Sector Undertakings (PSUs), including Infrastructure Development Finance Company (IDFC), Power Finance Corporation Ltd (PFC) amongst others, have also played a pivotal role in project finance. These PSUs could have made a significant contribution in the future as well if not for their failure in raising resources from the market and inability to channelize the existing resources. With the rapidly increasing demand for investment in infrastructure, an urgent need has been long felt to develop alternative financing mechanisms.
The primary alternative financing mechanisms include domestic capital market; foreign investments; bilateral and multi-lateral financial agencies; and private sector participation. Let us now analyse these mechanisms.
The corporate bond market is of immense significance for financing infrastructure development. In India, however, the use of domestic market funds has been somewhat restricted due to the underdeveloped domestic capital market. Although RBI has taken measures over the last decade to strengthen the bond market, the development of the corporate bond market is far from satisfactory. The chief problem area is that, in India, corporate bonds have short maturity period, within five years, whereas the funding requirements for an infrastructure project is usually for a period of over ten years. Hence, it is not ideal for funding the long-run requirements of such projects.
With the integration of the financial markets across the world, an alternative avenue has opened up for financing the long-term capital requirements of infrastructure projects. In India, initially, the flow of foreign funds was primarily in the form of short-term portfolio investments rather than longterm foreign direct investments. In order to encourage the flow of foreign funds into the infrastructure sector, the Finance Ministry has allowed the Foreign Institutional Investors (FIIs) also to invest in unlisted companies. FIIs can now invest 100 percent of their funds in the infrastructure sector in India. This move is aimed at helping infrastructure companies as they are not in a position to list their shares in the initial phase. Further, in a bid to make the core sector attractive for FDI, automatic clearance for foreign investment (not requiring the approval of the FIPB) was first introduced for infrastructure sectors like power and roads. Currently, 100 percent FDI is allowed under automatic route in the infrastructure, with the only exception of telecom (49 percent).
In the wake of the recent global financial crisis and tightening of the credit from commercial banks and bond markets, multilateral financial agencies are emerging as the preferred lenders for infrastructure developers in India. Institutions such as the World Bank and the Asian Development Bank (ADB) are protected from the global crisis to an extent because they raise funds from their member nations and bond markets. However, companies cannot directly borrow from most bilateral and multilateral lenders and often have to get proposals cleared from government departments.
An increased private sector participation/investment for capital investment in the infrastructure sector is also critical. The Government has been trying to harness the private sector’s efficiencies in meeting the infrastructure needs of the country either through fully private ventures or through public private partnership (PPP). It involves participation of Central and State Governments along with the private sector. For achieving this, some regulatory aspects and transparency issues have to be dealt with. Recent studies indicate that pursuant to the success of reforms in transport and telecommunication sectors, India has attracted most of the investment commitments to infrastructure projects with private participation in the South-Asia region, as compared to any other developing country. Infact the Eleventh Five-Year Plan contemplates more than USD 500 Billion worth investment in infrastructure by the year 2012, and PPPs are projected to account for nearly 30 percent of the proposed investment.
The structuring of the project vehicle is a crucial first step towards ensuring smooth execution of the project. A number of different structures are available to ‘sponsors’ to structure the project vehicle. Some of the most common ones are a joint venture; partnership; limited partnership; a limited company. Of these structures, the joint venture and limited company structure are the most universally used. The question whether the sponsors follow the joint venture, i.e., direct investment route or the limited company, ie, indirect investment route, depends on a variety of legal, tax, accounting and regulatory issues, both in the home country of the sponsor and the host country of the project.
At the core of the project finance transaction is the ‘concession company’ which consists of the consortium of ‘shareholders’ comprising investors or contractor or operator. Pursuant to the concession agreement, the rights for the project are awarded through a ‘concession’ from a public authority for a fixed period of time. Typically, the concession company is structured as a special purpose vehicle (SPV) which manages the infrastructure project. This concession usually entitles the SPV to build, finance and operate the facility for that period. At the end of the concession or project agreement, the primary contract is entered into between the granting authority and the SPV. It is this contract which forms the contractual basis from which other contracts are developed in the project structure.
The SPV is incorporated as an independent legal entity under the provisions of the Companies Act 1956 and is governed by its constitutional documents, i.e., memorandum of association and articles of association. Additionally, the concession agreements, tender documents and final award contracts also have a bearing on the functioning of the SPV, since these documents stipulate the conditions in accordance with which the project has to be undertaken. The SPV, in turn, enters into contractual agreements with the various parties necessary in a project finance transaction. Since the SPV has the ownership of the project assets, it also becomes the borrowing vehicle for the project. The nature of SPV varies depending on the legal and financial agreements with the concerned stakeholders in the project. Different infrastructure projects have different structures of SPV and no single SPV structure is suitable for all projects. To put it differently, the SPV has to be structured upon considering the financial and legal attributes of the project. Factors like finance-ability of the project, sources of fund for the project, securities and agreements, government support to the investors, amongst others, are to be considered.
Jefferey Delmont once said, ‘risk is the likelihood of a detrimental event occurring’. Risk is undoubtedly one of the most determining characteristics of project finance. As the project is given effect through an SPV, the lending bank in a project financing can in no way get access to the assets of the borrower and must instead look to the project itself as far as the question of recovery is concerned. It is but obvious that a higher risk involved in a project therein would trigger a higher rate of interest than it would ordinarily do, say, in a corporate lending. Risk management is a huge challenge in any project finance and is generally done in the following four stages:
While making the choice of the applicable law, what is crucial is the extent to which the Indian legal system recognises the enforceability and validity of an agreement. Practically speaking, it is necessary to determine whether the Indian legal system will permit the law of some other jurisdiction to govern the financial transaction with which it has little or no connection. In most cases, Indian law will recognise the choice of law by the parties as long as the intention expressed is bona fide and not contrary to any law or public policy. Financing documents wherein foreign lenders are involved are generally governed by the applicable foreign laws. But the security documents having nexus with Indian assets would be governed by Indian laws as the security will ultimately have to be enforced in India.
In any complex infrastructure project with multiple stakeholders, disputes and disagreements are bound to arise, thereby threatening to disrupt the project. The importance of overseas arbitration provisions cannot be over-emphasised. In the event of a dispute, the arbitration mechanism will enable the parties to avoid the inordinate delays that commonly plague the Indian courts. Arbitration in an international project finance transaction is a matter of voluntary submission. According to the arbitration law of India enshrined in the Arbitration and Conciliation Act 1996, reciprocity is granted for enforcement of foreign arbitral awards passed under the New York Convention and Geneva Convention, provided the matter decided in such arbitration should be capable of being decided by arbitration as per the laws of India. The Supreme Court attempted to reinforce, to some extent, the Indian courts’ commitment to recognise and enforce foreign awards in the case of Renusagar Power Co. Ltd. Vs. General Electric Co reported as (1994) 2 Arb LR 405. However, this judgment was devoid of comprehensive guidelines for further instance of the courts’ interference in the enforcement of the foreign awards.
We may safely conclude that successful execution of a project finance demands an extensive analysis and calculation of the risks involved in each project. The challenge lies in developing feasible and flexible mechanisms to effectively and practically mitigate the concerned risks. From the Indian perspective, it would be also fair to say that project financing will require the legal fraternity to play a bigger role as everything from power generation to the development of ports and natural gas exploration calls for extremely competent lawyers. A major concern in the Indian ‘infrastructure space’ has been the regulatory risks, with too many questions unanswered on the issue of undecided tariffs for several infrastructure sectors. In an emerging economy like India, where the demand for infrastructure far outweighs the economic resources, the need for enormous debt and capital, coupled with the risks involved in large scale project development, makes project financing one of the few feasible financing alternatives in the energy, transportation, and other critical infrastructure industries. Looking at the tremendous investments taking place in the power, telecommunications and township development sectors, we believe the best of project finance is yet to be!
Rohit Sharma Associate Vice-President, (IDFC Ltd, Mumbai)
The major issue in project financing is that of land acquisition. The State Governments are trying to do their best to counter this, but so far nothing much has been done. A lot of projects have been delayed because of land acquisitions, especially NHAI projects. They always tend to overrun their time, largely because the Government is not able to obtain the necessary land in time. The issue of bureaucracy is another major hurdle, for e.g. getting orders or sanction of the government authorities. Suppose, we have to execute a project finance on power, we need the approval of the Electricity Board for the tariff. Since the tariff orders are not easily available, it further delays the project. Another issue is that of rehabilitation. As per the law, whenever one acquires any land for project, one is obliged to rehabilitate the affected people. Sometimes the guidelines are not clear as to how the rehabilitation is to be done.
First and foremost is the ‘legal title’ of the land on which the project would be based and how the land is to be acquired. Sometimes, if the project is being done on an agricultural land, the permission of the Government is sought. Secondly, compliance with the local laws is also a major consideration. Laws differ with every state in India and a local lawyer is to be approached for sorting out the legal complexities.
In NHAI Concession Agreements, parties have an arbitration mechanism. There is, however, a proposal that we have a dispute resolution mechanism similar to that in the West. For example, in Australia, if there is a construction project dispute, it is normally referred to an arbitration panel comprising engineers.
I would say, most of them are satisfactory and few of them are good. Explaining the commercials to few lawyers is sometimes difficult because what I have noticed is ‘generalists’ do the work of ‘specialists’ in India and the quality is somewhat compromised that way. So, law firms need to train their lawyers accordingly. At the same time, we have to appreciate that ‘project finance’ is still a very new practice area and the best is yet to come.
Jatin Aneja Partner, Amarchand & Mangaldas & Suresh A. Shroff & Co.
The key concern of the financier prior to the provision of any project finance is identification and mitigation of risks, i.e. events which may potentially result in the project (i) not being completed in accordance with specified time lines or within the prescribed budget (ii) not being able to operate or continue to operate at identified operational parameters and levels (iii) not being able to generate sufficient revenues to service the debt or provide necessary returns on equity, and/or (iv) not continuing to subsist for the entire projected project life.
The preliminary step both in determining the best mix of debt and equity financing for a project, as also in drafting the appropriate documentation for any financing, is then is to undertake a feasibility study of the project (and the sector), coupled with a due diligence exercise and financial modelling to identify each of the associated risks and the potential extent and impact thereof. From a general perspective risks associated with a project, crucial for a diligence exercise can be identified as follows:
The selection of the right instruments for raising the necessary project finance for any project is essentially linked to two factors (a) the gestation period and the viability thereof (b) the ‘security package’ that can be created for the financier. The former is a key determinant of the nature of the financier and the period within the returns/repayment of the project finance can be expected while the latter is a key determinant of the extent of the finance that can be obtained.
In the Indian context, project financing initially relied extensively on the long term debt from banks and financial institutions in conjunction with sponsor equity, and state support.
A major distinction between debt based financing and equity based financing structures is the method of repayment, which in the case of the former is linked to a payment in instalments at specified interest rates and in accordance with specified repayment schedules, while in case of the latter is envisaged as return on the equity (upon the expiry of a specified period), obtained through a transfer/sale of the equity to the project sponsors and/or to third parties (often guaranteed and/or secured though by the project sponsors).
Projects risks are unique to each sector, with varied impact and emphasis, as differing on the characteristics of the relevant sector and nature of the project, for example the construction risks which are crucial for large power projects would be far less significant in the context of the telecommunication projects where the emphasis shifts to market risks. Thus, as each project has its own risk profile, the risk mitigation structures, and the financing mix, will vary depending on the specific circumstances of each project.
Further, given the varied nature of the risks and the involvement of many participants, including pro¬ject sponsors, lenders, investors, governmental agencies, and regulatory authorities, risk mitigation arrange¬ments, the resulting the contractual documentation for project finance for each can at times be rather complex and inter-alia involve detailed legal and contractual agreements that:
Jay G. Safer Partner, Locke Lord Bissell & Liddell LLP (New York)
Xanthe M. Larsen Partner, Locke Lord Bissell & Liddell LLP (Washington, D.C.)
India provides some of the greatest opportunities for investment because of its sustained growth of just over 7% (8% projected for 2010) per year, its large middle class, and the U.S. Government’s continued focus on increasing U.S. investment in India. However, certain barriers to trade and investment remain which create risks for developing and financing projects in India. These risks include project completion, political and regulatory risks. Investors in India will need to navigate and structure for issues with existing high tariffs, insufficiently developed infrastructure, currency convertibility difficulties and restrictions on foreign ownership of real property and equity in Indian companies.
For U.S. investors, many of these risks can be mitigated through assistance from the U.S. Government such as the Overseas Private Investment Corporation, the Export-Import Bank of the United States and the Obama administration’s National Export Initiative. Xanthe: In my opinion, India has a robust and developed legal system, that although may be overburdened and slower, has a generally good record of providing fair remedy to foreign investors.
Well, the key due diligence considerations would include determining whether the permits and regulatory approvals needed to undertake the project will be obtainable, ensuring that local partners and agents needed to structure the project are credible and reliable, obtaining good localized information about the region (state) in which the project will be situated, and determining the type of collateral package that can be provided to lenders despite the ownership issues surrounding common key project assets.
Project developers should be aware, and find experienced assistance to help them carry out the project finance. The fact that real property laws in India are fairly intricate and complex and that there are no land registries makes it even more complex. Accordingly, confirming and ensuring clear title to real property is another important due diligence consideration for any major project. Lastly, because a significant factor for developing successful projects in India and avoiding disputes is developing good local relationships, it is important to ensure that the project partners with only credible and experienced companies and individuals. Obtaining this comfort requires an investment in independent verification and background checking services.
Over the past 20 years, India has instituted trade and economic reforms that have made its trade regime more transparent to outside investors and developers. Additionally, India has worked to decrease tariffs from a high of 350 percent in 1991 to around 10 percent today. These reforms have helped open India to significant foreign investment and development. On the other hand, India’s laws restricting foreign ownership of real property and equity controlling ownership in Indian companies create challenges for project owners and lenders and may create priority issues for non-Indian creditors. Additionally, some industry sectors remain highly regulated and cannot be directly invested in without specific governmental approval (including certain sectors of agriculture, atomic energy and rail), although recent legislation has tended towards greater liberalization in the area of foreign direct investment.
Of concern to project owners and lenders alike is the issue of nationalization. Projects in India in recent decades have faced a relatively low risk of expropriation and certain ongoing disputes (such as the Dabhol power project and those of certain U.S. power sector investors in the State of Tamil Nadu) have been resolved or significant progress has been made in their resolution in recent years. These factors mitigate usual political risk concerns for sponsors and lenders.
As we said earlier, the legal system in India provides a fair forum, but not always a timely resolution. In India, most laws are well documented, which provides predictability. Additionally, the court system in India is well-established, accessible and generally viewed as fair to foreign investors and owners. However, the courts in India are overburdened and resolving a dispute through the court system can take time and patience. But as you know, alternative forums of dispute resolution is supported in India and India is a party to several international arbitration conventions.
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