Sovereign Guarantees in Project Finance
One of the most attractive features of project financing is that it allows the sponsors of a project to guarantee the obligations of a special purpose project company in lieu of incurring direct obligations. Being contingent obligations, guarantees need not be reflected on the guarantor's balance sheet. However, guarantees are required to be disclosed in footnotes to financial statements in accordance with the prescriptions of the United States Financial Accounting Standards Board. Indeed, rating agencies often take note of a sponsor's contingent liabilities, particularly when such liabilities are substantial. Nonetheless, the impact of such guarantees on a sponsor's credit profile is, by far, much less severe than an equivalent direct liability on its balance sheet. Guarantees have therefore become one of the keystones of project finance.
Sovereign guarantees are given by host governments to assure project lenders that the government will take certain actions or refrain from taking certain actions affecting the project. Although a blanket sovereign guarantee of all project risks is impossible to obtain in any project finance transaction, many of the legal and political risk categories typically encountered in an infrastructure project will be well within the host government's ability to control and may therefore be fairly allocated to such host government.
In theory, the government is forced to accept risks such as exchange rate and political risk because it is better able to manage it through sound economic policies. In practice, however, the heavy debt burden under which many a developing country is laboring may be compounded when, during a period of economic difficulties in the host country, the beneficiaries of a guarantee ask the sovereign to make good on its promise. As the current financial crisis in Asia shows, very few emerging market nations are able to withstand the resulting stampede. The value of a sovereign guarantee is further constrained by the sovereign debt ceiling. As a result, many lenders are taking a second look at, and in some cases finding ways to avoid, the need for such guarantees through, for example, other risk mitigation measures such as political risk insurance from multilateral, bilateral and export credit institutions as well as private insurance companies. But even where the government is financially strong, a government's willingness to give a guarantee will depend as much on the degree to which it is committed to the project as on its perception of what the market will bear. As competition to win deals in these emerging markets heats up, more and more sponsors are finding it harder to convince host governments to execute guarantees, particularly where competitors exist who have found other ways to mitigate the offending risks.
Where a sovereign guarantee is not obtainable, the host government may yet be willing to execute a somewhat watered-down document with questionable enforceability, sometimes called a "comfort letter," or a "memorandum of understanding." Such instruments may cover one or more of the following matters (many of which may also be covered in the concession):
- Policy statement by the host government, acknowledging the importance of the project to the nation's economy, and supporting foreign investments in the development, construction and operation of infrastructure projects.
- Assurances that the project company will be able to open and maintain foreign currency accounts in any financial institution within or outside the host country.
- Assurances that tariff and concession regimes permitting recovery of actual project costs and a reasonable return on capital shall remain in full force and effect and shall be adjusted only to the extent necessary to guarantee the project sponsors no less than the agreed upon return on capital.
- Guarantee by the central bank that it will allocate hard currency towards debt service and repatriation of capital or profits and that it will also ensure free convertibility, transfer and timely remissibility of foreign exchange whether converted through normal commercial channels or otherwise.
- Guarantee by the host government of obligations of all local governmental instrumentalities (such as the central bank, the agencies responsible for furnishing water, fuel electric power and other utilities to the project) involved in the project.
- Host government assistance such as grants of real property and utilities at nominal fees, exemptions from withholding taxes, income taxes, import duties and other taxes to enhance financeability of a project.
- Assurances that the host government will not expropriate (without prompt, adequate and effective compensation) the project or otherwise treat the project or the project sponsors in a discriminatory manner and that the project will be entitled to no worse benefits than any other similar project in the host country.
- Assurances that no change in the environmental, tax, import/export or other laws and regulatory framework will be applicable to the project if such change will have a material adverse effect on the project, or the rights of the project sponsors or the lenders in the project.
- Assurances that the host government will expeditiously grant and renew all governmental approvals and permits, including work permits, visas and other foreign worker permits for project participants and their personnel. Assurances that the host government will not (in connection with any privatization or otherwise) sell or otherwise transfer any interest in any primary obligor or project counterparty without taking steps to ensure that the project and the project sponsors and lenders will not suffer adversely thereby.
- Assurances as to timely installation and completion of new ancillary infrastructure such as transportation and utilities necessary for the construction, operation and maintenance of the project.
- Assurances that the project company or its sponsors will be free to expand its operations and business in areas related to the project as and when such new opportunities are open to the private sector.
- Indemnification by the host government for any loss sustained by any project participant by reason of the invalidity or unenforceability of any provision of any agreement, permit, instrument or other document executed or delivered by any instrumentality of the host government.
- Assurances that the project company will have the right to procure and purchase full insurance and other goods and services abroad if the local costs of any such goods and services exceed, which, for example, 10% of the foreign cost of an equivalent product or service.
- Guarantee by the host government of the obligations of the offtake purchaser, or in the absence of such an offtake purchase agreement, guarantee of minimum levels of use of the infrastructure that is the subject of a concession.
- Assurances that the government will not grant any competing franchises or concessions while the project debt is outstanding.
- Assurance that the host government will not unduly interfere with the operation, administration and maintenance of the project.
It is instructive to note that although many emerging market infrastructure projects utilizing project financing have been conceived, most have been stillborn mainly because sovereign guarantees have been impossible to obtain. A majority of emerging economy project financings that have come to fruition have had to rely on the assistance of the IFC, MIGA and various other bilateral, multi-lateral and export credit agencies.