José R Prado Jr and Roberto K C Bonometti, Machado Meyer Advogados
In project finance transactions, the project’s cash flow is the primary source of funds to service loans, and the financing risk matrix mainly comprises the risks of the project and the ability of its sponsor to implement it. Unlike traditional corporate financing transactions – which are generally structured with corporate guarantees of the shareholders and/or assets of the borrower – project finance transactions are mainly structured with securities over the project’s revenue, assets, rights and equity. However, as the greater value of a project is in its operation and capacity to generate future cash flow, project finance transactions frequently include the possibility for lenders to exercise their step-in rights into the company, upon the occurrence of certain events in which the project company has failed in its obligations to third parties, and where that failure may affect the continuity of the project, rather than enforcing securities over the assets. Therefore the aim of step-in rights is to provide lenders with the possibility to cure defaults or improve the operation capacity of the project company, or both, and thus preserve a company’s activities by putting it back on track. Lenders can take over project control in several ways, acting in accordance with the terms and conditions of the project structuring that allocate risk and events that may trigger it, and that limit liabilities. However, in civil law countries such as Brazil, limiting liabilities may be constrained by substantive laws.
Step-in rights can be derived from legal provisions or contractual arrangements. Subject to certain restrictions in the applicable legislation, the most common contractual mechanisms for lender’s step-in include:
The step-in rights described in this final item, which apply to lenders (or any third party appointed by them), include the following:
Brazilian Concession Law (Law No. 8.987 of 13 February 1995) and Brazilian Public-Private Partnership Law (Law No. 11.079 of 30 November 2004) provide two mechanisms for lenders and guarantors to step-in project companies that are concessionaires of public services for promoting the financial restructuring and ensuring the continuity of the service provision. These mechanisms are taking control of the project company’s shares, and temporary administration of the company. While the takeover of control comprises taking possession of the project company’s shares as a result of the enforcement of security interests over shares, the temporary administration comprises the takeover of the project company’s management by appointing managers and members of the board of directors, vetting resolutions of the shareholders and taking other actions required for putting the project company back on track, without transferring the shares ownership. Moreover, the Brazilian Concession Law provides that in the event of a temporary administration, lenders are exempted from liabilities, charges, penalties and encumbrances claimed by third parties, including those arising from labour claims and the granting authority.
Contractually arranged step-in rights under Brazilian law are typically structured through usufruct of shares, whereby lenders would be able to temporarily step into the shoes of the shareholders of the project company in a situation of default, to approve the necessary actions to correct specific issues and ensure compliance with the project company’s contractual obligations. Given the specific purpose of its exercise (ie, restructuring the financials of the project company and/or guaranteeing the continuity of the object of the project company), step-in rights granted under such a security interest might be limited to the non-economic rights of the shares, including voting, information and monitoring rights. Under such arrangements, lenders will be entitled to take all measures that an ordinary shareholder would deem necessary to correct specific issues and ensure compliance with the project company’s contractual obligations, including replacing the board and managers, preparing the company for foreclosure, among other things. Therefore, by exercising step-in rights through usufruct of shares, the lenders would have the ability to direct or indirectly control the project company to ensure compliance with its obligations without taking over control of the project company’s shares.
Contractually arranged step-in rights under Brazilian law are also structured as conditional assignment of contractual position, which allows the lender step-in rights to the contractual position of the project company under the project agreement. The conditional assignment of contractual position, if requested by lenders, requires prior authorisation of the project counterparty and may result in the assumption of contractual obligations and liabilities under such an agreement by the lenders and/or its appointee. Consent to the right of the lender or any appointee to step into the contractual position of the project company under the project agreements, either temporarily or as a permanent substitution, is generally obtained by means of direct agreement to be entered into by the project company, the project agreement counterparty and the lender.
Under Brazilian law, parties cannot agree in advance that, in the event of a default, the creditor can take possession and assume ownership of the asset over which the security interest has been created as an in-kind payment of its credit. If the debt is to be paid by means of the foreclosure of the collateral, a creditor must promote its judicial or amicable private sale and satisfy its credit rights with the proceeds of such sale. This restriction applies not only as a rule, but also as a principle, which imposes certain limitations to the exercise of step-in rights, including in relation to term of the step-in.
The step-in has to be temporary because the exercise of a step-in right for an excessive period of time could be considered as an alternative to take the pledged assets as in-kind payment, which would violate the aforementioned prohibition. There is no legal or judicial guidance on the maximum period of time for the exercise of the step-in rights as the term will depend on the specific circumstances of each case, but it should be no longer than is sufficient for the lender to restructure the financials of the project company and/or guarantee the continuity of the project.
Nonetheless, the exercise of step-in rights could expose lenders to some adverse effects in Brazil, especially in relation to exposure to liabilities and the treatment of creditors in judicial reorganisations.
Shareholders are not liable, in theory, for the obligations of the company in accordance with the concept of limited liability to their shareholders. However, there are some instances in which the Brazilian courts and/or law authorise piercing the corporate veil and reaching the personal assets of shareholders, or holding shareholders strictly liable to provide potential interested third parties and creditors with extra tools to satisfy their claims. Such mechanisms might be extended to lenders who exercise stepping into project companies.
Under Brazilian law, in cases where an employer has defaulted on its labour obligations, its shareholders and those involved in the management and/or control of the company may be deemed jointly responsible for such obligations to the company’s employees. Brazilian courts have held shareholders liable for labour claims brought against the company in which they have equity, despite the fact that only the company could be considered as the direct employer. In fact, labour and employment liability may be extended to the company’s shareholders, and hence the lenders exercising the step-in – not only based on the piercing of the corporate veil doctrine but also on a joint liability regime that is recognised in respect of all entities considered to be within the same economic group, if such a group is characterised.
Another risk that lenders stepping into a project may face relates to environmental liabilities. Pursuant to the Brazilian environmental national policy (Law No. 6.938 of 31 August 1981), all corporate entities or individuals directly or indirectly involved in damaging activities are deemed to be polluters and as such may be jointly and severally liable for the recovery of the environment. In addition, Brazilian environmental national policy authorises the piercing of the corporate veil whenever the existence of the corporation could jeopardise the recovery of environmental damage. Because of such authorisation to pierce the corporate veil, and the joint and several liability, one could expect that shareholders of a corporation and lenders stepping in could eventually be held liable for environmental damage caused by such a legal entity.
Nonetheless, the Brazilian Clean Company Law (Law No. 12.846 of 1 August 2013) provides that companies may be held strictly liable for acts against the public administration, in the civil and administrative spheres, including those in which it has not directly engaged, but has benefited from their result (ie, the shareholders or, ultimately, the lender exercising step-in). In those cases, the culpability of the shareholder or the lender exercising step-in would be taken into account when establishing which sanctions would be applicable and on measuring it.
Exercising step-in rights may also affect the lenders’ rights in a judicial reorganisation. Pursuant to Brazilian Bankruptcy Law (Law No. 11.101 of 9 February 2005), shareholders of the debtor, as well as its affiliates, controllers and controlling entities, may be prevented from voting in the insolvent debtor creditors committee during a judicial reorganisation procedure if it has stepped into the company. In the Grupo Schahin judicial reorganisation, the Brazilian courts ruled that the lender who has stepped into the project company and appointed its management was prevented from voting in that company’s credit committee.
To restrain such liabilities arising from step-in, the Brazilian Concession Law and the Brazilian Public-Private Partnership Law provide exemptions to lenders’ liabilities in the event of temporary administration of project companies that are public services concessionaires, including those related to taxes, charges, penalties and encumbrances claimed by third parties, as well as penalties applied by granting authorities or resulting from labour claims. However, if a lender proceeds with the step-in by taking over the control of public services concessionaire shares, there might be some questions if an exemption is also not applicable. There is also some controversy if an exemption of liabilities applies only to existing liabilities or future liabilities, as well as if it is applicable to project companies that are not public services concessionaires. Setting such standards clearly may be an important incentive for lenders to exercise these rights and thus diminish their exposure to risk and adverse effects in Brazil.
Even though Brazilian courts have yet to rule and set standards on the extension of the exemption to liabilities, especially in situations in which the step-in results in temporary administration of project companies by the lenders, step-in rights are an efficient mechanism to mitigate lenders’ risks in project finance transactions by empowering them with the ability to take over control of a project and put it back on track.