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Wednesday, May 29, 2013

Managing Lender Liability in Equator Principles Implementation - Legacy Liabilities (Post-Loan following Repayment or Default)

This post will consider a rather controversial topic - the possible existence of liabilities linked to Equator Principles (EP) implementation that may extend beyond the life of the underlying loan or activity to which the EP were originally applied.

The purpose will be to consider whether there are plausible legacy liability risks affecting EP implementation and, if so, how such risks could be managed by Equator Principles Financial Institutions (EPFI) before they materialize.

Please note that, as this is a blog post, the analysis is high level and intended to raise points for reflection and thought rather than to be an exhaustive review of the law on these subjects. Hopefully it raises some useful considerations and I am very much open to comment (and criticism) of the topic and ideas put forward. The goal is to generate a dialogue that may help push the boundaries of our understanding of these issues.

At a recent speaking engagement I, along with my co-panelists (an environmental lawyer and an environmental engineer), raised the question of how (if at all) legacy liabilities arising from Equator Principles (EP) implementation are managed in practice by Equator Principles Financial Institutions ("EPFI" - meaning Equator Principles signatories). In particular, how decommissioning obligations that are part of the required covenants of the EP are enforced (if at all) if decommissioning does not take place until a loan is repaid.

The question was met, it turned out, with some indignation from the audience that we would even suggest there could be risks or obligations for EPFI extending beyond the life of a loan. Surely it is the case, it was suggested in response to our brazen question, that the EP is only intended to apply during the life of a loan.  To think there are any risks or obligations that extend beyond that is therefore absurd and the question we posed, irrelevant.

I must admit, the reaction, and the certainty with which it was delivered, surprised me. It left me wondering whether I (and the panel) was completely off-base to have even asked the question.  Or, whether perhaps the audience members who provided the retort were overly optimistic that their lack of control over borrowers once an EP loan is repaid eliminates all risks or legacy liabilities for EPFI from that date forward. 

Upon further reflection, I'm only more convinced of the possibility that legacy liabilities exist for EPFI even once loans are repaid.  To illustrate the point I've thought of a few possible scenarios where this could be the case, that may be worth considering when drafting EP documentation and managing EP implementation in relation to a project.  If I'm indeed right about the plausibility of such scenarios, then any remaining over-optimism may suggest that a review of risk management practices is needed by the industry.  I would however, be glad to be wrong. In any event perhaps it will be some food for thought and fodder for discussion.

Scenario 1 - Post-Loan Decommissioning

The most obvious post-loan risk scenario relates to decommissioning. The new EP III requires (as did its predecessor) that, for all Category A and B projects, a client will covenant that they will "decommission the facilities, where applicable and appropriate, in accordance with an agreed decommissioning plan".  Nothing in the EP that I've identified makes clear that this requirement is only intended to apply during the life of the loan. The use of the phrase "where applicable and appropriate" tells us nothing about the nature of this commitment once the loan has been repaid. In fact the only reference to "during the life of the loan" I have found in the EP III relates to the obligation of the EPFI and borrower to conduct monitoring, which doesn't have any clear relationship to the decommissioning requirements.

As required by Principle 8, this decommissioning covenant will typically be found in the contractual documentation that structures the loan, possibly as a representation of the borrower or as a condition precedent requiring the production of a decommissioning plan prior to the financial close of the deal. However, practically speaking, it will be unlikely a decommissioning plan can be drafted prior to financial close, a period of time possibly prior to construction of the project. Decommissioning plans will be developed when decommissioning is actually being done, at the end of the life of the project. Most project related loans will be fully repaid long before the end of the life of the project. What this means is that an EPFI will have none of the financial leverage over their borrower to enforce this required covenant regarding decommissioning that they would have during the life of the loan.  But is that the end of the story? Possibly not.

First of all, if it is known from the outset that decommissioning will not take place until a period of time beyond the life of the loan, then what is the purpose or intention of these decommissioning covenants? Is such language intended to create post-contractual obligations on borrowers to carry out decommissioning in a manner consistent with the EP whenever it happens?  Can an EPFI enforce this obligation on a borrower other than through leveraging events of default or collateral? Could, for example, such provisions be enforced beyond the life of the loan through a claim for specific performance or compensatory damages associated with a failure to develop a decommissioning plan?

To put this in context, let's consider a possible scenario. What if there was NGO or Affected Community complaints or protests alleging the failure of an EPFI's borrower to develop and implement a decommissioning plan. The protests tarnish the EPFI with the same brush, accusing the EPFI that sponsored the project of not meeting its commitments regarding decommissioning of the project. Let's imagine the loan has been repaid and the EPFI has no financial leverage over the borrower when the controversy ensues.  Let's say also that the borrower has clearly decided not to develop a decommissioning plan in accordance with the standards contemplated by the EP and contracted for in the documentation for the EP loan, that allowed the project to proceed in the first place.

From a simple reputational risk perspective, this scenario would be troublesome for an EPFI. Clearly the borrower's actions have put the EPFI's reputation at risk, causing likely commercial harm. Arguing that the loan had been repaid and that the EPFI has no leverage over the borrower would not absolve the borrower of this necessarily. Would the EPFI have a claim against the borrower for such damages? Could they seek an order requiring specific performance of the decommissioning covenants from the underlying agreement, complying with EP standards?

Let's now imagine that the Affected Community brings a legal claim or lawsuit against the project proponent and the EPFI alleging that their public commitments to decommission the project in accordance with the EP was not carried out. In defending the claim, could the EPFI bring a cross-claim against the project proponent to enforce the decommissioning commitment it had made as part of the loan?  This could be a vital defence strategy for an EPFI, that finds itself embroiled in litigation over the decommissioning of a project that has long been off of its books from a financial perspective.

The answers to these questions are not easy to answer without serious reflection and cannot be shunted aside as an "impossibility". In some jurisdictions, the solution could turn on the intention of the contracting parties and the language of contractual documentation. EPFI should therefore give close consideration to what exactly the purpose of the decommissioning covenant is and whether and how it will be effectuated beyond the life of the loan. Importantly, they should consider whether this intention is actually reflected in a plain reading of the EP and their contractual documentation.

If there is no intention on the part of the EPFI to have any involvement in the decommissioning phase of the project, then there should also be thought given to why such language is being included at all (either in the EP as a "required" covenant or in contractual terms).  Including such commitments with no intention to implement them could, in itself, create risks of fraudulent misrepresentation that could give rise to undesirable liability for the parties, including an EPFI.

In managing such risks, if not clearly addressed in the loan documentation itself, EPFI could consider whether a post-loan separation agreement with the borrower may be useful and necessary to clearly extinguish the obligations of the EPFI once a loan is repaid. Such agreements could include indemnification language, that would oblige borrowers to indemnify EPFI for claims against the borrower in relation to environmental and social matters resulting from the borrower's failure to meet the expectations of the EP or applicable standards. This might also correct any contracts that exist on an EPFI's books that maybe did not consider these issues adequately when they were originally drafted.

While the above is just brainstorming, it illustrates possible risks and responses facing EPFI post-loan in respect to decommissioning issues.

Scenario 2 - Allegations of EPFI Misrepresentation or Fraud

Another type of post-loan legacy EPFI liability that should be examined is the risk that a representation or finding in relation to EP compliance made during the life of the loan could be found to have been inaccurate or false, leading to possible liability for misrepresentation after the loan has been repaid.

For example, the EP require that project Assessments be conducted and EPFI endorsed Action Plans be developed regarding the legal and regulatory compliance (for environmental and social matters such as labour, ohs, indigenous relations and human rights issues) of the project and where applicable, compliance with the IFC Performance Standards and EHS Guidelines. EPFI commit to monitoring and reviewing such compliance for the life of the loan. Public reporting by the borrower and EPFI takes place, including disclosure of documentation to Affected Communities and other stakeholders. Assessments of legal and regulatory obligations and ongoing compliance monitoring and reviews and development of management plans and action plans regarding project level legal and regulatory compliance are developed as part of the EP implementation process. 

Perhaps surprisingly, these legal and regulatory assessments, plans and compliance reviews are often not developed or even reviewed by qualified lawyers. Should such assessments be incomplete, inaccurate or incorrect, despite the commitments of the EPFI to address such matters in partnership with their clients, could this create risk of a misrepresentation that could create liabilities even after the loan has been repaid?

Let's consider a couple of scenarios that may illustrate the potential manifestation of such risks.  What if, post-loan, the project itself was sold. Typically in an acquisition process there will be a process of due diligence and commitments from the seller to the purchaser that there has been legal compliance and that certain business practices have been followed. There may also be representations and warranties regarding environmental and social liabilities that may be passed onto the purchaser. External reviews of legal and regulatory and risk management practices would certainly be relevant to such due diligence.

Would a purchaser (or a borrower being legally challenged by a purchaser) be entitled to rely upon the representations of legal and regulatory and best practice compliance overtly or tacitly endorsed by an EPFI in the course of their EP oversight activities? If such assessments were inaccurate, deliberately or negligently, would there be the potential for recourse against the EPFI by the interested purchaser, or borrower in the nature of a cross-claim?  What liability risks exist for representations regarding EP compliance made by EPFI or their agents?  Do these risks extend beyond the life of the underlying financing?

Considering a slightly different scenario, what if an Affected Community has relied on representations made by or on behalf of the borrower and EPFI in the course of stakeholder engagement or in carrying out the project. Would those stakeholders potentially have a claim against the EPFI in the event that (even post-loan repayment) it were discovered that the project had in fact not been carried out in accordance with the legal and regulatory and best practice expectations of the EP? Could an intentional misrepresentation even be considered fraudulent? These are all very complex legal questions that cannot be answered in this short post, but should be the subject of further reflection by EPFI and their counsel.

So how could these types of risks be managed? First and foremost, the best management strategy would be to ensure that EP commitments are properly carried out. This would mean having properly qualified advisors involved in making assessments about compliance (which is primarily legal and regulatory compliance in accordance with Principle 3 of the EP) on the project. The independent review process would be a critical time to ensure this is done. Aside from the obvious benefit of having properly trained persons making the required compliance assessments, there is also the issue of professional indemnity insurance which typically does not cover advice that falls outside of the competency of the professional giving the advice. This could affect the ability of the EPFI to recover for negligent advice that affects their own legal situation.

As with the decommissioning scenario, there may be a need for a "close-out" type of agreement that clearly defines the end of an EPFI's responsibilities.

Indemnification language may also be prudent to shift the monetary effect of any possible liability onto the borrower, if this is the desired outcome when the initial financing is being negotiated.

Finally, contractual language should be as clear as possible that the contract itself does not create rights for third party beneficiaries who may seek to enforce the contract.  This topic of third party beneficiary rights will be the subject of a future post.

Scenario 3 - Regulatory prosecutions for Co-Manager Liabilities

The EP III states that: "As financiers and advisors, we work in partnership with our clients to identify, assess, and manage environmental and social risks and impacts in a structured way, on an ongoing basis." Throughout the EP III (and its predecessor) reference is made to the EP as a "risk management" framework.

It is well known that lender liability risks for environmental and social matters may arise from operational or managerial control by a lender over a project. Most legal regimes impose liability for environmental, health and safety and labour standards on those persons or organizations with operational or managerial control, possibly including lenders. There may also be personal liability for managers and directors of a project, where environmental or social liabilities arise. Moreover, there can be liability for "aiding" or "abetting" regulatory violations, meaning that a person (including possibly a lender) knew or ought to have known about a regulatory violation but did nothing to prevent it. This type of liability could easily arise in the course of EP implementation, where EPFI are auditing and assessing legal and regulatory compliance of their borrowers, and even suggesting management approaches through the Action Plan and monitoring and review processes.

To the extent that a managerial relationship with a project proponent were found and a project became the subject of a regulatory prosecution for environmental and social issues, it is conceivable that an EPFI holding itself out as working "in partnership with our manage environmental and social risks" could be sucked into the resulting litigation.  This could potentially include the risk of personal liability for employees, directors and officers of EPFI.

While there may be time limitations for government regulators to take action for regulatory violations, but it is possible that such limitations could expire well beyond the life of a loan.  As such, there is the possibility that an EPFI could become embroiled in litigation as a legacy to a loan which had already been repaid. This creates a clear legacy liability that reamins on an EPFI's books and must be managed to the extetn possible.

To avoid this particular risk, EPFI should avoid the mantle of "co-manager" of a project and not exercise operational control over the project to the extent possible.  This may be quite challenging since the EP itself is worded as a process involving EPFI as partners in management of environmental and social risk.  What will be more important than wording, however, will be the actual role of the EPFI in the operational decision making of the project. In practice, the EP were not designed to create operational control of projects by lenders, but rather to act as a private governance framework for the project administered through contractual relationships.

Avoidance of managerial control would not, however, alleviate the risks associated with aiding and abetting regulatory offences. Another important step will therefore be to ensure that assessments of compliance, including legal and regulatory compliance of the project, are as accurate as possible. Again, this can be done by ensuring qualified professionals are opining on compliance questions. Doing so will avoid the risk of regulatory prosecutions that such compliance oversight is designed to identify and avoid.

As well, in order to avoid complete disclosure of all internal documentation regarding legal compliance assessments (which could be held against the borrower or EPFI in a regulatory prosecution) to investigating regulatory authorities, legal professional privilege should be attached to internal analyses to the extent possible.  This necessitates that the document originate in the provision of legal advice from a qualified legal practitioner when the document is created, in the provision of legal advice.  Action plans, Assessments and independent monitoring and review reports created in the implementation of the EP, opining on the legal and regulatory compliance of the project, could reasonably be considered as legal opinions deserving of legal professional privilege, so long as they are created by qualified legal professionals. Legal professional privilege plays a critical role in managing the context and disclosure of information to regulators scrutinizing an EPFI or borrower's conduct in relation to a possible regulatory offence.

Scenario 4 - Borrower Default and Bankruptcy

Another scenario I've come across in the literature is the situation of a default or bankruptcy resulting in a lender taking ownership and control of a borrower's operations.  It is possible, in other words, in the event of a borrower default, that an EPFI or its agent could takes a controlling interest and managerial role in the project as part of a bankruptcy or collateral arrangement.  This could contingency could give the EPFI a clear operational role in managing the project or status as a project owner that could enhance the potential for liability of the EPFI for the environmental and social liabilities of the project. It would also heighten the importance of good environmental and social practices for the project.

Such risks could be managed by contingency planning to account for the heightened control of a project that may result from a default, in light of EP obligations. Such contingency planning should take into account the risk of enhanced environmental and social liabilities, including those arising from the application of the EP to the project. This could include taking steps to avoid operational and managerial control over the project, as discussed in scenario 3 above. It is also a reason to ensure that the EP is implemented as accurately as possible, to avoid the assets being tarnished by poor environmental and social practices - which is the basic purpose of the EP in any event.

A note on EP Document Retention

In light of the foregoing risks, it is also imperative that EPFI give consideration to document retention of contracts, Assessments, Action Plans, monitoring information and reviews.  Such materials and other EP documents (including even notes and correspondence) could be of critical importance to addressing legacy liability issues long after a loan is repaid.  In the event of litigation, there could even be legal requirements to ensure such documentation is available and not purged or destroyed. Identifying the proper retention period for such EP related documents should consider these potential legacy issues and not simply when the loan is financially off-the-books.  This easily overlooked point highlights why consideration of these post-loan issues is important from both a strategic and administrative perspective.


 In light of the foregoing, it is, in my view, prudent to consider legacy liabilities in developing strategies for both how EP contracts are developed and how the EP is implemented. Such planning and foresight must look past simply the financial end of a EP financing and instead look to the types of liabilities that can extend beyond that point.

Questions for Discussion:

To readers involved in the banking and risk management industry, here are some questions:

1.  What (if any) other legacy risks do you think there are for EP implementation?

2. What strategies do you think should be implemented to manage them?

3. How should the foregoing hypothetical scenarios be addressed, if at all?

4.  What would be a proper retention period for EP related documents?

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