Double security? Assessing the role of direct agreements and security cessions in project finance transactions

A defining feature of project finance is that it is ordinarily limited recourse funding, which means the lenders rely only on the revenue of the project itself and the assets thereof, to recover their investment. For that reason, project finance transactions present a high risk for lenders, particularly in respect of greenfield projects. Due to such risk, principally during the pre-operational stage of a project, a good security package which mitigates risk to the greatest extent possible, is essential to protect lenders’ interests.

In addition to finance and security documents, a project finance transaction also includes project documents such as construction agreements, operation and management agreements and equipment supply agreements. One of the finance documents typically applicable in project finance transactions are direct agreements in respect of the material project documents. Direct agreements are ordinarily concluded between the lender, or in the case of a syndicate of lenders, the security agent, the borrower and the counterparty to the project document. Such agreements provide the lender(s)/security agent with step-in rights in the event of the failure by the borrower to fulfil its obligations in terms of the relevant project document. Accordingly, before a counterparty can terminate a project document on account of the borrower’s breach, the lender(s)/security agent will be given an opportunity to “step in” and fulfil the borrower’s obligations thus ensuring the continuity of the agreement and consequently the project.

In addition, project finance security packages often include the cession of project documents by the borrower in favour of the lender(s)/security agent. Cession of project documents ordinarily takes the form of a cession in securitatem debiti (security cession) as opposed to an out and out cession. In terms of a security cession, the borrower will cede its personal rights in respect of the project documents to the lender(s)/security agent as security for its obligations under the debt facility. While the borrower will retain ownership of the ceded rights, the lender(s)/security agent will obtain the right to enforce such rights against the project document counterparty in the event of an occurrence of an event of default under the facility agreement.

Direct agreements and security cessions aim to ensure that notwithstanding the borrower’s default, the project can continue in order to reach an operational stage and generate revenue. Given that both direct agreements and security cessions provide the lenders with a form of step-in rights, it would appear that concluding both documents constitutes “double security”. A question which might arise is why would lenders need both? As indicated above, the aim when preparing a security package, is to mitigate the risk borne by lenders to the greatest extent possible. An assessment of the characteristics of direct agreements and security cessions, as summarised above, will reveal that while both agreements relate to the lenders’ rights in respect of the project documents, they offer different protections which are complementary as opposed to repetitive. While on one hand, direct agreements allow lenders to step-in and fulfil the borrower’s obligations in the event of breach of a project document by the borrower, security cessions on the other hand, provide lenders with the option to step-in and enforce the borrower’s rights against the counterparty in the event of breach of the facility agreement by the borrower.

From an enforcement perspective, direct agreements give lenders rights in the event of a breach of the project document in order to prevent the counterparty from terminating same should the borrower be unable to remedy such breach, whereas a security cession gives the lenders rights on the occurrence of an event of default under the facility agreement. Even though it has become market practice, to draft facility agreements such that breach of a project document will constitute an event of default under the facility agreement, the counterparties to the project documents are not party to the facility agreement and accordingly facility agreements do not have a mechanism in place to prevent the counterparty from terminating the relevant project document or ceasing to perform in relation thereto. Direct agreements and security cessions give lenders a direct relationship with the counterparties which enables them to facilitate continuity of the project.

Although including both direct agreements and security cessions in the transaction documents package may appear repetitive, they each play a different role and provide the lenders with more comprehensive security. The two documents complement each other in creating the lenders’ rights and combined they give lenders favourable options regarding the project.