Running head: Assignment 4

FERNANDO LUZERNO AUGUSTO CARLOS LICHUCHA

Distance Learning Doctorate of Finance

Program

This assignment is submitted in partial fulfilment of the

requirements for 5524S1861 DF Project Finance R2

School of Management
Professor Dr. Igor Gvozdanovic

July 31, 2016

Assignment 4

Please answer the following questions in the form of a

short essay:
a. Describe the following and explain their importance in
project finance:
I. Contractors bond
II. Representations and warranties
III. Events of default
IV. Reserve accounts
b. What are the advantages and disadvantages of loan
covenants?
c. Project finance covenants are not particularly
important for the successes of projects. Discuss
d. Of what special significance in project finance are
Security agreements?

Assignment 4

Table of contents
Describe the following and explain their importance in project finance.....................4
Contractors bonds................................................................................................... 4
Representations and warranties.............................................................................. 4
Events of default..................................................................................................... 5
Reserve accounts.................................................................................................... 6
What are the advantages and disadvantages of loan covenants?..............................6
Project finance covenants are not particularly important for the successes of
projects. Discuss....................................................................................................... 7
Of what special significance in project finance are Security agreements?.................8
References.................................................................................................................. 9

Assignment 4

Describe the following and explain their importance in

project finance
Contractors bonds

According to (Fight, 2006) Contractors bonds provide ways of incentivizing

or securing the performance of contractors, subcontractors and suppliers. So,
the types of bonds are (i) bid (or tender) bonds require the bidder to pay a
penalty should they be awarded the contract and decide to withdraw. Bid (or
tender) bonds aims to prevent fraudulent bids designed solely to deprive
competitors the work (Fight, 2006), (ii) performance bonds guarantee
performance by the contractor for a certain proportion (perhaps 5% or 10%)
of the contract price, (iii) advance payment guarantees to enable the
contractors to purchase materials and begin working on the contract. and if
they do not begin (or complete beginning) working on the project, that they
will
have to refund the advance granted, (iv) retention guarantees provided by
the contractor for the project company to retain a specified percentage of
the progress

payments, in order to repair defects which may not

immediately be apparent. Conversely, the contractor wishing to receive full

payment may instead offer a guarantee for the equivalent amount of the
retention guarantee, (v) maintenance bonds to cover defects which are
discovered after completion of construction.

Assignment 4

Representations and warranties

A representation is a statement by a contracting party to another contracting
party only about a past or present fact that is correct on the date when
made. Facts required to be true in the future are covenants. warranty is a
complement of a representation and in practice the two terms are used
together, the contracting party being asked to represent and warrant
certain facts (Fight, 2006).
The two main conditions underlying the initial representations and warranties
are a) to ensure that the legal status of the company exists, as this governs
the ability to enforce the contract against a presumed set of assets, and (ii)
to ensure that the contracting party is duly authorized to enter into the
transaction (Fight, 2006)
Therefore, the representations and warranties are a check list of the key
elements that lenders need to review in their due diligence to confirm that
they are satisfied with the risks of the financing. (Yescombe, 2002).

Events of default
Events of default are those events, which, should they occur, permit the
lender to require all amounts outstanding to become immediately payable.
The typical events of default clauses are (i) failure to pay amounts owing to
the lender when due, (ii) failure by the borrower to perform other obligations
under the loan agreement, (iii) any representation or warranty made by the
borrower proving to be untrue, (iv) cross-default, i.e. where the borrower has

Assignment 4

triggered an event of default or has actually been put into default on any
other loan agreement, and (v) material adverse change occurring in the
borrowers financial or operating position (Fight, 2006).
Events of default specific to project finance transactions and not typically
present in commercial lending include (i) non-payment of interest or principal
constitutes an event of default, (ii) breach of covenants, (iii) breach of
representation or warranty, (iv) filing of bankruptcy petition, (v) final
judgments rendered against the project company, any project sponsor or any
major project participant, (vi) final acceptance date, (vii) failing to obtain,
maintain, renew, or replace government approvals or permits, (viii)
abandonment of the project by the project company, (ix) n expropriation, whether a
complete taking or an act of creeping expropriation, (x) Failure of the project
sponsors to maintain either an agreed-upon ownership interest or voting control of
the project company, (xi) if the project company, any project sponsor or any major
project participant, such as the contractor, operator, off take purchaser or supplier,
defaults in a payment obligation in excess of a specified amount, (xii) if any party to
a credit support document, such as the sovereign under a sovereign guarantee, or
any credit support obligation under a project contract, is not paid when due, and
(xiii) if any security document, such as a security agreement, stock pledge
agreement or mortgage, ceases to be in full force, or is no longer effective to create
a first priority lien on the collateral, then an event of default occurs..

Reserve accounts

Assignment 4

Reserve accounts ensures that the project entity is protected in the event of
any future legislative or regulatory changes by maintaining several accounts
with the project trustee such as a reserve account, a debt service reserve account,
or an environmental legislation reserve account (Fight, 2006).

What are the advantages and disadvantages of loan

covenants?
Covenants are undertakings given by a borrower as part of a term loan
agreement. Their purpose is to help the lender ensure that the risk attached
to the loan does not unexpectedly deteriorate prior to maturity. The loan
covenants have four key functions which can be also equated to advantages
(i) to place some restraint on the danger that a company may become
financially distressed. This is achieved, for example, by gearing limits, (ii) to
provide the banker with an early warning if, nevertheless, a company is
beginning to have problems or is significantly changing the nature of its
operations, (iii) to limit the extent to which borrowers can take actions which
they may be particularly tempted to do when approaching financial distress,
and (iv) they can be used to trigger loan default if necessary (Fight, 2006).
The disadvantages of loan covenants are a) at some time during the term of
a loan a once-relevant covenant may require amendment due to a change in
circumstances, however, this may be costly to achieve, especially where a
company has many bilateral agreements all requiring amendment or a
syndicated facility requiring a large majority, or even unanimity, to agree
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Assignment 4

amendments, (b) contractual restrictions on management activity can turn

out to be more costly than the damage they are intended to limit, (c) setting
inappropriate levels for ratio covenants may place unnecessary restrictions
on the borrower and may trigger an unwarranted default (Fight, 2006).

Project finance covenants are not particularly important

for the successes of projects. Discuss
Project finance covenants are undertakings by the Project Company either to
take certain actions ("positive" or "affirmative" covenants), or not to do
certain things ("negative" or "protective" covenants). It is through the
covenants that the lenders exercise their continuing control over the
construction and operation of the project (Yescombe, 2002).
The main purposes of the covenants are: (i) to ensure that the project is
constructed and operated as agreed with the lenders, (ii) to give lenders
advance warning of any problems that might affect the Project Company,
and (iii) to protect the lenders' security (Yescombe, 2002). Given these
arguments project finance covenants are definitely important for the
successes of projects because they deal with the very fundamental
philosophy of project finance which is non-recourse structured finance, the
means and the ways of how the debt will be for sure paid back.
Finally, according to (Fight, 2006) unlike asset based transactions, project
finance covenants are designed to closely monitor and regulate the activities
of the project company and deal with a variety of agency costs between
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Assignment 4

shareholders and lenders by negotiating covenant structures that are

contained in loan agreements (Jensen and Meckling, 1976) as cited in
(Finnerty, 2007).

Of what special significance in project finance are Security

agreements?
Security agreements guarantee the lenders the ability to take effective
control over the contracts and keep them in place to enforce security
through (i) security documents and (ii) security on specific tangible assets
(Fight, 2006). Security documents

record the required security interest

including (i) mortgages or fixed charges over land, buildings and other fixed
assets, (ii) fixed and/or floating charges over moveable assets, and
production/work in progress, (iii) assignments of rights under underlying
project documents (e.g. construction contracts, performance bonds, licenses
and joint venture agreements), (iv) assignments of project insurances and
brokers undertakings, (v) assignments of sales contracts, take-or-pay,
throughput or tolling agreements escrow accounts to control cash flows
relating to the project; (vi) assignments of long term supply contracts, (vii)
assignments of project management, technical assistance and consultancy
agreements, and pledge of shares of project company, including charge over
dividend rights. Whereas, security on specific tangible assets specifically
charged will usually include the following (i) the tangible assets used in the

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facilities, (ii) fixed assets, (iii) the license or other operating permits, (iv)
technology and process licences (Fight, 2006).

References
Fight, A. (2006). Introduction to Project Finance. Great Britain: Elsevier.
Finnerty, J. (2007). Project Financing: Asset-Based Financial Engineering (2nd ed.).
New York, NY: John Wiley & Sons.
Yescombe, E. R. (2002). Principles of Project Finance. Amsterdam: Academic Press.

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