Jose Prado, Adriano Ferreira and Paloma Lima of Machado Meyer Sendacz e Opice discuss current trends in Brazil.
With the upcoming sporting events of global importance in Brazil, as are the 2014 FIFA World Cup Brazil and the Rio 2016 Summer Olympic Games, the country is being faced with the challenge of increasing and improving its infrastructure in every area, including power generation and supply, transportation (ports, airports, roads and railways), among others. In this scenario, it appears to us that there are two important concerns to be addressed. First, it is to create a proper incentive for the private sector to finance these infrastructure needs. The other is the identification and use of contractual structures suitable to enable the success of these large construction projects underway in the country. Let’s talk first about the recent incentives created for the financing of infrastructure projects, and then move on to the contractual structures that could be adopted to build these projects.
Brazil is currently experiencing an unique moment in its history, with unprecedented growth and business and commercial opportunities. The continuity of such growth, however, faces several challenges, being a major one the development of our infrastructure. The Brazilian government plays an important role in the financing of the infrastructure projects in our country, mainly through the Brazilian development bank Banco Nacional de Desenvolvimento Econômico e Social (BNDES). While BNDES is supposed to continue financing such transactions, it is common sense that, due to size and number of the projects needed and the amounts involved, private investments must play a significant role.
In order to foster long-term private investments in the infrastructure sector, the goverment last year published Law No. 12.431, which created certain tax incentives for securities issued in Brazil. These tax-incentivised securities are being called “project bonds”. The tax incentives are mainly related to the reduction of the withholding income tax rate on the interest paid under such securities and they apply differently to Brazilian and foreign investors. We will only discuss the tax incentives for foreign investors.
For foreign investors, once the securities comply with the requirements set forth in Law No. 12.431, a zero rate will apply to the withholding income tax on interest payments. Investments on such qualified securities will also benefit from a zero rate on the tax on financial transactions (IOF).
In order to qualify for the tax benefits described above, the Project Bonds must be issued by non-financial Brazilian private entities to foreign investors not located in tax-haven jurisdictions through a public offering in Brazil and comply with the following requirements:
• interest must be pre-fixed, linked to price index or to Brazilian reference rate;
• the average maturity must be greater than four years;
• the issuer may not repurchase the securities within the first two years after the related issuance or early redeem or repay the securities;
• the investor shall not have assumed any commitment to resell the securities;
• interest payments should occur with intervals of at least 180 days;
• securities must be traded on regulated markets; and
• the proceeds of the offering must be applied on a new investment project (capex).
It is worth noting that, in order for the tax incentives to apply to Brazilian investors, the proceeds of the offering must be applied into an infrastructure project approved by the government. No such governmental approval is needed in case of a project bond whose public target is the foreign investors.
There has so far been no issuance of such tax incentivised securities in Brazil. This is because there are some doubts related to the requirements described above and who will assume the consequences in case of failure to comply them. The government is now working on an amendment to Law 12.431 in order to resolve such doubts, which we expect to occur in the coming months.
That said, it is now important to consider bankable contractual structures that could be used in order to build infrastructure projects.
CONSTRUCTION CONTRACTUAL AGREEMENTS
The more traditional engineering, procurement and construction (EPC) agreement remains unmatchable in terms of the overall protection offered to the project owner and financiers, in relation to a series of risks common to construction activities, maximising the predictability of budgets and schedules, mainly due to the following characteristics:
• contractual scope including all engineering services, projects, civil works, supply, assembly, installation and all other activities necessary for delivery of a ready-to-operate industrial facility;
• fixed global and lump-sum price, subject to restricted revision;
• pre-agreed term for conclusion of all works and delivery of the project, subject to a liquidated damages delay penalty; and
• a single contractor or consortium of contractors concentrating all duties and responsibilities under the contractual scope, including any subcontractors which it may choose to involve.
However, such widespread protection may sometimes entail excessively high costs for the project owner. In this sense, the feasibility of certain construction projects may require innovative contractual solutions that allow an efficient risk-allocation structure (acceptable to both contractors and project owners), while providing the project owner and financiers with a minimum level of comfort as to timing and costs for completion. As a result, the customary EPC contractual regime has in some cases been replaced by others.
One example is the engineering, procurement and construction management agreement (EPCM), under which the contractor assumes responsibility for the management of all activities required for completion of the project, but as a general rule will not directly execute these activities, except for the preparation of the basic and executive engineering project.
The EPCM contractor will select, manage and monitor the third parties who will perform the project implementation activities. Compensation is usually negotiated on a man-hour basis or consists in a margin over the cost of the activities contracted with third parties. An advantage of this contractual form is the fact that the project owner will have an independent and qualified manager to seek out the best constructive solutions and third-party contractors. However, the EPCM contractor will not assume risks for the services delegated to third parties.
An aspect common to both EPC and EPCM agreements is that a single contractor or consortium of contractors is the counterparty concentrating responsibility for the activities necessary for completion of a project. Another alternative would be for the owner of a great construction project to opt for the segregation of the contractual relationship, attributing different duties to different contractors, the sum of which would result in a complete project.
This segregated regime poses several challenges for the project owner and the project itself, including problems in the coordination and monitoring of the different scopes, ensuring that the sum of all contracts effectively encompasses all items necessary for project completion, as well as difficulties in the identification of the exact source of any problem that may arise and the use of the appropriate contractual remedy.
Said risks could, however, be mitigated through the use of an alliance agreement, which is based on an innovative construction contract regime known as integrated project delivery (IPD). Under this regime, the owner, the main contractor, the project designer and the main suppliers contractually conceive a fictitious entity in order to execute a specific project by means of mutual and integrated cooperation. Nevertheless, the entity is not a corporate entity and the parties do not formally become partners who will share the profits and losses of a traditional venture. The multilateral alliance agreement will attribute specific tasks and goals to each party, for the execution of a common project.
The project will continue belonging exclusively to the owner and the alliance will cease to exist upon project completion. In general, the owner will share with the other parties any additional gains resulting from a positive outcome of the alliance (ie, early completion, cost efficiencies etc). On the other hand, if the project is concluded with an overall negative result, the contractor, the designer and the suppliers may receive compensation below market average, as a manner of participating in the failure of the project.
Alliance agreements are, therefore, structured to enable the alignment of parties, which will be naturally motivated to jointly achieve higher standards of project execution and efficiency. This alignment should be pursued through detailed contractual provisions that clearly describe responsibilities, goals and rules for the sharing of the project outcome. For this reason, alliance agreements may take longer to draft and negotiate compared to EPC and EPCM agreements.
The Brazilian government, mainly through BNDES, plays and will continue to play an important role in the financing of the infrastructure projects in our country. Due to the agenda related to the upcoming sporting events in Brazil and the country’s needs in order to uphold a continued growth, the government is trying to foster the private investment; hence the creation of tax incentives for the issuance of securities (project bonds) in Brazil. Due to certain doubts related to the requirements for the qualification of such tax incentives, and who would assume responsibility in case of failure to do so, no issuance of such project bonds has been made so far. The government is working on an amendment to the law in order to resolve such issues. Regardless of such discussion, in order to attract foreign investment, the construction contracts of such projects must be bankable. Although Brazil somewhat lacks practical experience in the use of more innovative instruments, with the analysis of consolidated international legal practices, local players can find a way to design contractual structures that are up to date and suitable for the country’s current needs.