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Financial and Contractual Structure of Construction Projects


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Independent Study Project with Professor Nicola Chiara
Spring 2007

Published in: Business, Economy & Finance
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Financial and Contractual Structure of Construction Projects

  1. 1. Construction Project Financial and Contractual Structure An Independent Study Project Spring Semester 2007 Sakib Khan SEAS ’07 Advised by Professor Nicola Chiara
  2. 2. My Goals: <ul><li>Improve understanding of finance mechanisms in place for large scale construction projects </li></ul><ul><li>Develop understanding of the breadth and depth of contractual agreements in large scale construction projects </li></ul><ul><li>Gain insight on the ethical implications of contractual structures and international construction projects in developing nation situations </li></ul>
  3. 3. Objectives: <ul><li>Develop descriptive diagram of major relationships between major parties in typical project finance arrangements </li></ul><ul><li>Present notes on sequence of contracts, legal instruments, and key memos and reports over the stage of project development </li></ul><ul><li>Identify and think about areas of potential ethical or moral dilemma </li></ul>
  4. 4. Source Texts: <ul><li>International Project Finance . Ronald Sullivan. 4th Edition. Huntington, NY: Juris 2004. </li></ul><ul><li>Principles of Project Finance . E.R. Yescombe. San Diego: Academic Press 2002. </li></ul>
  5. 5. My Grand Diagram
  6. 6. Project Company Investors Equity Lenders Feasibility Study Pledges Local Government Permits Permissions Exceptions Obligations Intent to develop Organized Labor Union deal Engineers Environmental Impact Statement Completion Agreement Purchaser Product Guaranteed Sales Contract General Contractor Contracts Design Debt Profit GC financing Operator Input Supplier Off-taker Not studied: Collateral
  7. 7. Notes on Sequence A sketch of possible key documents over the development of a typical project
  8. 8. Stage 1: Financing the Project
  9. 9. [1] Subscription Agreement <ul><li>Parties: Investors </li></ul><ul><li>Project Company </li></ul><ul><li>Obliges Investors to supply equity to the Project Company </li></ul><ul><li>Subject to exchange regulations and government limitations of foreign investment </li></ul>
  10. 10. [2] Feasibility Study <ul><li>Parties: Investors (by way of I-Bank) </li></ul><ul><li>Lenders </li></ul><ul><li>Detailed description of project </li></ul><ul><li>Information on the investors, similar investments </li></ul><ul><li>Outline of all agreements and contracts </li></ul><ul><li>Detail of all costs, to-date and projected </li></ul><ul><li>Detail on finance structure and attempts </li></ul>
  11. 11. [3] Offering Memorandum <ul><li>Parties: Project Company (by way of I-bank) </li></ul><ul><li>Lenders </li></ul><ul><li>Establishes amount to be loaned </li></ul><ul><li>Describes: </li></ul><ul><ul><li>Investors’ investments </li></ul></ul><ul><ul><li>Project completion </li></ul></ul><ul><ul><li>Management structure </li></ul></ul><ul><ul><li>Terms of loans </li></ul></ul><ul><ul><li>Guarantees of insurance </li></ul></ul><ul><ul><li>Restrictions on sales of assests </li></ul></ul><ul><ul><li>Limits on working capital ratio, debt service </li></ul></ul><ul><ul><li>Choice of law </li></ul></ul><ul><ul><li>Environmental considerations for due deligence </li></ul></ul>
  12. 12. [4] Commitment Letter <ul><li>Parties: Project Company </li></ul><ul><li>Lenders </li></ul><ul><li>Lender outlines commitments necessary to make loan </li></ul><ul><li>Not legally binding, but typically followed </li></ul>
  13. 13. [5] Intercreditor Agreement <ul><li>Parties: Lenders </li></ul><ul><li>Forum for joint administration between lenders </li></ul>
  14. 14. [6] Mortgage or Indentured Trust <ul><li>Parties: Project company </li></ul><ul><li>Lenders </li></ul><ul><li>Secured with real and personal property, as well as project revenues </li></ul><ul><li>Places lenders in primary position versus unsecured creditors and investors </li></ul><ul><li>Indentured trust is like a collective mortgage with trustee and beneficiaries </li></ul><ul><li>Guarantees by investors may accompany in other forms </li></ul>
  15. 15. [7] Security Agreement <ul><li>Parties: Project company </li></ul><ul><li>Lenders </li></ul><ul><li>Some jurisdictions do not cover personal property and assets in mortgage </li></ul><ul><li>Security Agreement allows lender to secure equipment, inventory, etc. </li></ul><ul><li>Often restricts sale or lease of equipment, encumbering by liens, maintenance of insurance </li></ul>
  16. 16. Investors Guarantees <ul><li>Parties: Investors </li></ul><ul><li>Lenders </li></ul><ul><li>[8] Pledge Agreement </li></ul><ul><ul><li>Allows for stock of project entity to be pledged to tender </li></ul></ul><ul><ul><li>Does not really cover equity, but allows lender to take equity holder rights and take charge of company in crisis </li></ul></ul><ul><li>[9] Stand-by Letter of Credit </li></ul><ul><ul><li>A bank (not an initial lender) agrees to cover loan payments and default expenses in time of default by project company </li></ul></ul><ul><ul><li>Typically secured by investors, but also sometime by purchaser </li></ul></ul>
  17. 17. [10] Completion Agreement <ul><li>Parties: Investors </li></ul><ul><li>Project Company </li></ul><ul><li>Lenders </li></ul><ul><li>Investors will make funds available to Project Company sufficient to pay completion costs past funds otherwise available </li></ul><ul><li>Also can be phrased as: Investors are obligated to make funds available to pay the obligations of the loan agreement </li></ul><ul><li>Lenders often insist on these agreements </li></ul>
  18. 18. [11] Sales Contracts <ul><li>Parties: Project Company </li></ul><ul><li>Purchaser </li></ul><ul><li>Stabilizes cash flow and reassures lenders and investors </li></ul><ul><li>Might be “Take or Pay”, where payments are not tied to delivery but are unconditional so as to assure lenders some project revenue </li></ul><ul><li>Often trustee of debt will receive payments and enforce purchaser obligation </li></ul>
  19. 19. Stage 2: Structuring the Project
  20. 20. [12] Retain local counsel <ul><li>Parties: Attorney for the project </li></ul><ul><li>Local attorney </li></ul><ul><li>In international projects, local counsel should come on board as soon as possible </li></ul><ul><li>Locally incorporates legal entities </li></ul><ul><li>Negotiates with local government </li></ul><ul><li>Assists with analysis of local tax implications </li></ul>
  21. 21. [13] Letter of Intent <ul><li>Parties: Unincorporated project group </li></ul><ul><li>Local Government </li></ul><ul><li>Non-binding preliminary outline of commitments Investors and Government are willing to make </li></ul><ul><li>Also known as “Memorandum of Understanding” or “Principles of Agreement” </li></ul><ul><li>Can be formalized as “Master Agreement” </li></ul><ul><li>Possibly could be introduced as subject to legislative approval </li></ul>
  22. 22. [14] Incorporation of legal entities <ul><li>Parties: Investors </li></ul><ul><li>Local Government </li></ul><ul><li>Fit structure for ideal tax situation </li></ul><ul><li>Generally: Parent company owns subsidiary which is interposed into host country and then owns project company </li></ul>Investing Parent Company Investing Parent Company Wholly-Owned Subsidiary Wholly-Owned Subsidiary Foreign jurisdiction Project Company
  23. 23. Structures and Agreements for Project Company and Investors <ul><li>Structures: </li></ul><ul><ul><li>Limited Liability Company </li></ul></ul><ul><ul><li>Joint-Venture </li></ul></ul><ul><ul><li>Partnership </li></ul></ul><ul><li>Agreements: </li></ul><ul><ul><li>[15] Shareholders Agreement </li></ul></ul><ul><ul><li>[15] Joint Venture Agreement </li></ul></ul><ul><ul><li>[15] Partnership Agreement </li></ul></ul>
  24. 24. Stage 3: Government Agreements, Concessions and Obligations
  25. 25. [16] Government’s Obligations <ul><li>Parties: Project Company </li></ul><ul><li>Local Government </li></ul><ul><li>Often the Government has incentive to help the project develop </li></ul><ul><li>Project Company can negotiate with the Government the obligation to provide infrastructure, including: </li></ul><ul><ul><li>Roads, rail links, ports </li></ul></ul><ul><ul><li>Utilities </li></ul></ul><ul><ul><li>Housing and schools </li></ul></ul>
  26. 26. [17] Exchange Control Consents and/or Exemptions <ul><li>Parties: Project Company </li></ul><ul><li>Local government </li></ul><ul><li>To tap the international capital market, Government permission is needed to allow capital to flow in and out of the host country </li></ul><ul><li>Project Company counsel works closely with Local Attorney to determine the restrictions on foreign borrowed capital and draft consents or exemptions as necessary </li></ul>
  27. 27. [18] Project Company’s Obligation to Construct <ul><li>Parties: Project Company </li></ul><ul><li>Local Government </li></ul><ul><li>If the Government is obliged to help with the project, the Project Company is obliged to construct the project </li></ul><ul><li>Key point to exert bargaining power over Government </li></ul><ul><ul><li>Set no firm completion date </li></ul></ul><ul><ul><li>secure right to expand </li></ul></ul><ul><ul><li>minimize duties and taxes </li></ul></ul><ul><ul><li>avoid Government influence on pricing </li></ul></ul>
  28. 28. [18] Project Company’s Obligation to Construct (cont’d) <ul><li>Project details: </li></ul><ul><ul><li>What is completion? </li></ul></ul><ul><ul><li>Expansion rights? </li></ul></ul><ul><ul><li>Right to import raw, construction, and operations materials? </li></ul></ul><ul><ul><li>Pricing? </li></ul></ul><ul><ul><li>Royalties? (for natural resource exploitation) </li></ul></ul><ul><ul><li>Sales restrictions in local market? </li></ul></ul><ul><ul><li>Export licensing </li></ul></ul><ul><ul><li>Term of agreement </li></ul></ul><ul><ul><li>Determine governing law </li></ul></ul><ul><ul><li>Dispute resolution method </li></ul></ul><ul><ul><ul><li>Better to use arbitration than Government’s judges </li></ul></ul></ul>
  29. 29. PC’s Protection from Government <ul><li>Parties: Project Company </li></ul><ul><li>Local Government </li></ul><ul><li>[19] Non-Discrimination Agreement </li></ul><ul><ul><li>Disallows Government from discriminating against Project Company </li></ul></ul><ul><li>[20] No Changes Agreement </li></ul><ul><ul><li>Attempts to bind future Governments to the Agreement </li></ul></ul><ul><li>Neither carry much practical weight </li></ul>
  30. 30. Utilities Purchase Agreements <ul><li>Parties: Project Company </li></ul><ul><li>Local Government </li></ul><ul><li>Utilities Companies (if not national) </li></ul><ul><li>[21] Power Purchase Agreement </li></ul><ul><li>[22] Water Purchase Agreement </li></ul><ul><li>[23] Waste Disposal Agreement </li></ul>
  31. 31. Transportation Access Agreements <ul><li>Parties: Project Company </li></ul><ul><li>Local Government </li></ul><ul><li>[24] Agreement to Build Port/Harbor Facilities </li></ul><ul><ul><li>Waterworkers’ unions “extremely militant” </li></ul></ul><ul><li>[25] Shipping Agreement </li></ul><ul><ul><li>Use of shipping lanes limited solely to national lines? Or free access? </li></ul></ul><ul><ul><li>Exemptions? </li></ul></ul><ul><li>[26] Railroad Siding Agreement </li></ul>
  32. 32. Tax Agreements and Exemptions <ul><li>Parties: Project Company </li></ul><ul><li>Local Government </li></ul><ul><li>[27] Tax Agreement for Expatrioted Employees </li></ul><ul><ul><li>Allows for foreign employees to pay lower taxes than natives of same tax standing </li></ul></ul><ul><li>[28] Project Tax Arrangement </li></ul><ul><ul><li>Fix a method of tax calculation for all project revenue </li></ul></ul><ul><ul><li>Exemptions from specific taxes, customs duties, interest on foreign loans </li></ul></ul><ul><ul><li>Creation of tax holidays </li></ul></ul><ul><ul><li>Keeping accounts in foreign currency </li></ul></ul>
  33. 33. Labor Related Agreements <ul><li>Parties: Project Company </li></ul><ul><li>Local Government </li></ul><ul><li>Organized Labor </li></ul><ul><li>Employment and Training of Indigenous Workers </li></ul><ul><ul><li>Can Government provide training? </li></ul></ul><ul><ul><li>Does Government restrict labor pool? </li></ul></ul><ul><li>Labor deals with necessary unions </li></ul>
  34. 34. Political Risk Insurance <ul><li>Parties: Project Company </li></ul><ul><li>Insurer </li></ul><ul><li>Only issued when intergovernmental agreement exists between host and sponsor countries </li></ul><ul><li>Insures against: </li></ul><ul><ul><li>Expropriation </li></ul></ul><ul><ul><li>Political violence </li></ul></ul><ul><ul><li>Inconvertibility of currency </li></ul></ul>
  35. 35. Stage 4: Design and Construction
  36. 36. [29] Retain Design Professional <ul><li>Parties: Project Company </li></ul><ul><li>Engineers (or Architects) </li></ul><ul><li>Pretty standard </li></ul>
  37. 37. [30] Environmental Impact Statement <ul><li>Parties: Engineers </li></ul><ul><li>Government </li></ul><ul><li>Detailed description of project </li></ul><ul><li>Required permitting information </li></ul><ul><li>Analysis of environmental impacts to: </li></ul><ul><ul><li>Hazardous Materials </li></ul></ul><ul><ul><li>Earth, Air, Water, and Shoreline </li></ul></ul><ul><ul><li>Vegetation and Animals </li></ul></ul><ul><ul><li>Natural Resources </li></ul></ul><ul><ul><li>Preservation and Recreation </li></ul></ul><ul><ul><li>Housing, Transportation and Public Services </li></ul></ul><ul><ul><li>Noise, Aesthetics, and Glare </li></ul></ul>
  38. 38. Site Acquisition, Zoning and Engineering <ul><li>[31] Site purchase or lease agreement </li></ul><ul><li>[32] Re-zoning application </li></ul><ul><li>[33] Locally-signed drawings </li></ul><ul><li>[34] Building permits </li></ul>
  39. 39. [35] Retain General Contractor <ul><li>Parties: Project Company </li></ul><ul><li>Contractor </li></ul><ul><li>Contract terms: </li></ul><ul><ul><li>Gross Maximum Price </li></ul></ul><ul><ul><li>Fixed Price </li></ul></ul><ul><ul><li>Cost Plus </li></ul></ul><ul><ul><li>Cost Plus with Guaranteed Maximum Price and Incentive Based Fee </li></ul></ul><ul><li>Contractor Financing </li></ul><ul><ul><li>BOT, DBO, DBFO </li></ul></ul><ul><ul><li>Bank guarantees promissory notes are saleable </li></ul></ul><ul><ul><ul><li>Waived right to off-set during dispute with contractor </li></ul></ul></ul>
  40. 40. Moral Issues <ul><li>Application to third world context is essentially a colonial enterprise </li></ul><ul><ul><li>Ideal structure for manufacturing and natural resources projects, which are exploitative </li></ul></ul><ul><ul><li>Also ideal for electric power generation plants, which are empowering </li></ul></ul><ul><li>Author has some troubling early passages </li></ul><ul><ul><li>Classifies dock-workers unions, in general, as “militant” </li></ul></ul><ul><ul><li>Looks to leverage third world governments into unfavorable positions with regards to completion date, expansion, taxes, duties, etc. </li></ul></ul>