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Monday, February 18, 2013

Making the Sustainability Case: The Convergence of Independent Reviews and Legal Risk Management in Equator Principles Implementation

The third iteration of the Equator Principles (EP) framework will be released in the first quarter of 2013. The revised framework will, like its predecessors, have substantial implications for billions of dollars in international project financings. It will also reinforce the importance of environmental and social reviews in addressing legal and reputational risks facing Equator Principles Financial Institutions (EPFI). This article highlights the critical role legal counsel can (and should) play in EP implementation - particularly in the independent review process required by Principle 7.

EP as a Private Regulatory Process

EPFI can have diverse approaches to the implementation of the EP. Some EPFI have a highly decentralized approach, where implementation of the EP is managed by lending officers, with support from centralized risk management teams for higher risk projects. Some EPFI utilize advisory centres who provide technical support to front line business managers or lending officers who are ultimately responsible for EP compliance.

In-house legal counsel may have dotted line oversight of this process, but may not be closely consulted in the EP implementation process. This may derive from a view that the EP is a “credit risk” management framework and not a regulatory compliance process, and therefore not within the expertise of legal advisors. There is little in the EP to justify this view. “Credit risk” is mentioned only once in the EP framework – as a possible responsibility centre for EP implementation. “Compliance”, on the other hand, is mentioned 14 times and forms the foundation of the EP’s substantive requirements. “Compliance” is defined to mean legal and regulatory compliance for all EP projects. For some projects compliance additionally means the application of the International Finance Corporation (IFC) Performance Standards on Environmental and Social Sustainability. The requirements of the IFC Performance Standards are derived from the legal requirements of highly developed regulatory systems and therefore require legal analysis in their application. EP implementation requires a process of regulatory compliance due diligence and ongoing review and monitoring of that compliance over the life of the project.

Critically for the “credit risk” versus “regulation” debate is the fact that EP compliance is required regardless of whether compliance enhances the likelihood of loan repayment. Compliance is required for its own sake, in the same way as compliance with legal and regulatory requirements is mandatory regardless of whether there is a financial benefit in doing so. In light of these characteristics, there is a clear case to be made for the EP to be understood as a regulatory framework (albeit a private rather than publicly imposed one) and not a credit risk management framework.

There is a clear role for legal oversight here as there would be for any regulatory compliance exercise.

The “Sustainability Case” Approach to EP Regulation

EPFI themselves sit in the role of “regulator”, overseeing EP implementation for a financed project. This heightens, rather than diminishes, the complexity and risks involved in EP due diligence for EPFI, which may not be experienced in the application of regulatory theory in practice.

The approach to private regulation taken in the EP resembles “case” methods of regulation adopted by health and safety risk regulators in the United Kingdom, Australia and other jurisdictions. Safety Case regulatory regimes were introduced first in the United Kingdom following the Piper Alpha disaster in 1998. This regulatory strategy is now regularly used in relation to off-shore oil and gas production, nuclear, chemical, rail and other high risk industries.

The Safety Case approach to regulation focuses on risks and performance rather than simply a “tick the box” approach aimed at minimally meeting prescriptive requirements. A Safety Case regulatory regime requires the proponent of a project to identify risks associated with their intended commercial activity and propose to the regulator an effective plan to manage and mitigate those risks to an acceptable level. The Safety Case of the proponent is then vetted and challenged by regulators. This iterative process results in the development of an action plan for managing project risks that must ultimately be accepted by the regulator in order for the project to proceed. The Safety Case is a living document, which must be amended as the understanding of risks changes.

The “case” method to risk management permeates the approach of the EP, with the EPFI in the role of the regulator, challenging and vetting the borrower’s “Sustainability Case” for the project. Principles 1 and 2 of the EP require borrowers, in consultation with EPFI, to identify and assess environmental and social risks of a project, resulting in a document referred to as the “Assessment”. Principle 4 requires the borrower to develop a Management Plan to address risks identified in the Assessment process. The Assessment and Management Plan must then be critically evaluated by the EPFI. The EPFI will challenge the Management Plan and recommend additional or alternative compliance measures as appropriate. Once vetted, the EPFI will develop an Action Plan that will guide the borrower in achieving compliance for the life of the project. The Action Plan defines actions to address environmental and social impacts, the implementation of which can be tracked over time. The Action Plan is a “living” document that should evolve over the life of the project. Together, these components of the EP process constitute the “Sustainability Case” for the project and justify the EPFI’s decision to finance.

In EP III, management and action plans must be publicly disclosed, meaning their contents will be the focal point of stakeholder scrutiny and any future legal risks for the EPFI. If risks are being managed properly, it is clear that EPFI legal counsel must be fully cognizant of this process and satisfied with the project’s environmental and social compliance. This compliance and regulatory process is at the core of legal counsel’s expertise, making legal counsel an invaluable part of any EP implementation team.

Legal Risks for EPFI as Private Regulators

This begs the question, could legal liability arise if projects are categorized improperly, or projects fail to meet the expectations of environmental and social laws or the IFC Performance Standards, due to the deliberate or negligent actions of an EPFI? While this is an unsettled legal question, the risks of legal liability for EPFI are substantial and growing, as the EP become more entrenched in industry practice.

An interesting analogy to EP legal risks arises from the recent London Interbank Offered Rate (LIBOR) investigations and fines. LIBOR is the interest rate at which banks offer to lend to one another on the international inter-bank market. In June 2012 it became apparent that a number of banks had been manipulating LIBOR for their benefit to either make their positions look more secure, or to make a greater profit. Coming so soon after the financial crisis, this caused further negative press for the banks and resulted in a massive public outcry. Legal action was pursued against the banks by regulators. In June of 2012 Barclays was fined US$450 million dollars. On December 19, 2012, UBS, was fined US$1.5 billion dollars by the UK, Swiss and American authorities for its role in the manipulation of the LIBOR rate. Numerous civil law suits have also been filed in US courts and over twenty banks are still under investigation in relation to LIBOR manipulation, a number which is likely to increase following the UBS fine.

Like LIBOR, implementation of the EP process is not formally administered by governments. However, as was the case with LIBOR, EPFI create reasonable expectations in the market that their EP commitments will be implemented without negligent or deliberate misapplication. Should such commitments be deliberately or negligently breached by EPFI, there would be many avenues for potential legal consequences emerging from the detrimental reliance of market actors, shareholders or public regulators.

In addition, there are always risks related to public disclosures like those required by the EP, from privacy and confidentiality concerns to securities rules regarding project related disclosures. Such risks make it even more critical for EPFI legal counsel to be closely involved in overseeing EP implementation to ensure that the “private regulator” role of the EPFI is carried out in compliance with legal expectations, avoiding misrepresentations that could result in legal ramifications.

Independent Review – The Critical Juncture for Legal Oversight

A challenge may be that EPFI legal counsel might not view themselves as having sufficient expertise in environmental and social legal, regulatory or best practice requirements to have effective input and oversight of the EP implementation process. Lack of involvement by legal, however, risks a lack of oversight of a legal due diligence process with legal implications for the EPFI. The question becomes how opportunities can be found for such involvement to take place effectively.

In answering that question, EPFI should look closely at the role of legal in the “independent review” requirements of Principle 7 of the EP. Principle 7 of the EP requires that, for Category A and (as appropriate) Category B projects, a qualified independent firm not directly tied to the borrower and acceptable to the EPFI is appointed to review the Assessment, Management Plan and (if developed) the Action Plan for the project. Independent Reviewers are required to critically examine these documents to assist the EPFI's due diligence process, assess compliance of the project and propose a suitable Action Plan capable of bringing the project into compliance to the extent of any deviation, or to indicate if compliance is not possible for the project.

Active legal participation and oversight of this process can allow the EPFI to ensure that assessments of compliance are accurate and consistent with other due diligence that may be conducted on the project by legal counsel. It also provides an opportunity for broader legal risks of the project to be considered, including corruption and bribery risks, which have substantial legal consequences.

Practically speaking, the role of legal in the independent review process should be to vet the “Sustainability Case” of the project. This would require the involvement of several sub-specialist external legal counsel, with expertise on particular risks affecting the project – be they labour risks, occupational health and safety risks, human rights risks, indigenous relations risks or environmental risks. These specialist external legal advisors can aid the in-house counsel’s due diligence efforts by providing the technical expertise necessary to assess the project’s environmental and social risks. The review will culminate in advice regarding the Action Plan necessary to mitigate legal and reputational risks and achieve compliance on the project.

The benefit of this approach is a legally sound opinion on the environmental and social risks of the project that would not be possible in the absence of effective participation by legal counsel – internal and external. To achieve these important objectives, best practice would require that the independent review phase of EP diligence be “owned” by legal as the final arbiter of regulatory compliance for the organisation. Independent reviewers with specialist legal expertise on environmental and social requirements can assist in-house counsel vet the compliance risks of the project.

By utilising external legal counsel to act as EP independent reviewers, legal professional privilege can also attach to the independent review process, allowing for more open deliberation about the environmental and social risks of the project.


The adoption of the third EP framework is an ideal opportunity for legal counsel to re-examine their critical role in the EP implementation process. Legal counsel can add significant value to the risk management objectives of EPFI in implementing the EP. The independent review process required by Principle 7 of the EP is the ideal opportunity for legal advisors to vet and challenge the “Sustainability Case” for the project and ensure legal and regulatory compliance – the core requirement of the EP. Understanding the legal and regulatory nature of the EP is the first step in identifying the proper role for legal in the EP implementation process, to add value as partners and overseers of the EP process in achieving the financial and risk management goals of the EPFI.

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