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Tuesday, October 1, 2013

Equator Principles Financings – Mitigating Potential Legal Risks for Canadian Banks

Alison FitzGerald and Michael Torrance of Norton Rose Fulbright Canada discuss the legal risks for Canadian Financial Institutions associated with the recently revised Equator Principles (“EP”), whose third iteration (“EP III”) took effect on June 4th, 2013. The new EP appears to have caused little stir in the Canadian financial services sector or the legal community that serves it. The muted reaction might lead one to believe that EP III presents no significant legal risks for financial institutions (“FIs”). Alternatively, it may suggest that many of the risks inherent to the EP are poorly understood. This article looks at the EP framework and innovations to this framework adopted in EP III. We consider the potential legal risks presented by EP III for Canadian FIs and their clients, and offer some simple strategies to mitigate these risks.

I. The EP Framework and Innovations in EP III

The EP are an agreement amongst 78 global FIs (known as “EPFIs”), including seven Canadian FIs, whose purpose is to identify, assess and manage environmental and social (labour, human rights, aboriginal relations, occupational health and safety) risks in certain types of project financing throughout the world.

A fundamental principle of the EP is that EPFIs will not provide loans or financing to projects where the borrower will not or is unable to comply with the social and environmental requirements of the EP. EP III, like its predecessors, applies across industry sectors, but its scope has been widened to apply not only to project financings and project advisory work but also to project-related corporate loans and bridge loans, over applicable monetary thresholds.

a.) Priority of Legal Compliance

EPFIs are required under the EP to conduct due diligence on projects according to the magnitude of risk the project presents assessed against the environmental and social screening criteria of the International Finance Corporation (“IFC”). Although always a part of this process, EP III now emphasises the priority of legal and regulatory compliance relating to environmental and social issues. EP III now provides that the Environmental and Social Impact Assessment (“ESIA”) process should, “in the first instance”, address compliance with relevant host country laws, regulations and permits that pertain to environmental and social issues.

The effect of this re-prioritization is to underscore the importance of legal and regulatory compliance to the ESIA process. As a result, EPFIs must audit and monitor their borrower’s legal and regulatory compliance in implementing the EP.

b.) Going Beyond Compliance with International Best Practice

Beyond compliance with relevant host-country legal and regulatory requirements, EP III requires that projects in "Non-Designated Countries" (i.e., countries that do not have robust environmental and social governance legislation systems) comply with the “then applicable” IFC Performance Standards and Environmental, Health and Safety Guidelines. There are eight IFC Performance Standards relating to the following areas: (1) Assessment and Management of Environmental and Social Risks and Impacts; (2) Labour and Working Conditions; (3) Resource Efficiency and Pollution Prevention; (4) Community Health, Safety, and Security; (5) Land Acquisition and Involuntary Resettlement; (6) Biodiversity Conservation and Sustainable Management of Living Natural Resources; (7) Indigenous Peoples; (8) Cultural Heritage. These standards are intended to “fill the gaps” in the otherwise applicable legal regime of the project host-State.

 c.) Legal Covenants

As noted above, EPFIs commit in the EP to not provide financing to clients that cannot or will not comply with the EP. EP III therefore requires EPFIs to include specific legal covenants in financing documents regarding EP implementation to ensure that borrowers comply with the EP.

When a borrower is not in compliance with its social and environmental covenants, EPFIs are required to work with the borrower to bring it back into compliance. If a borrower cannot or will not re-achieve compliance, EPFIs can take remedial measures, including revocation of financing. The exercise of remedies in the face of borrower non-compliance is discretionary but must be consistent with the EPFI’s overarching commitment to only provide financing to projects that conform to the EP. Financing documentation must therefore include appropriately drafted representations, information covenants, project covenants and conditions precedent to ensure borrower obligations are properly set out.

d.) Public Reporting

EP III also sets out more stringent requirements for public reporting of environmental and social data, including requirements for annual EPFI reporting of diligence activity. This reporting must now include, at a minimum, the number of transactions screened by the EPFI, the categorization accorded to each transaction, and information regarding implementation. Such reporting may also be required and/or affected by securities and then reporting or disclosure requirements application to EPFIs and their borrowers.

e.) Greenhouse Gases Alternatives Analysis and Reporting

Under EP III, EPFI borrowers are required to undertake an “alternatives assessment” wherever Greenhouse Gas (GHG) direct (scope 1) and indirect (scope 2) emissions for a project are anticipated to be more than 100,000 tonnes of CO2 equivalent annually. This may coincide with any alternatives analysis required by a regulatory permitting process and therefore incorporates legal and regulatory requirements into the expectation.

f.) Human Rights and Labour Due Diligence

The new IFC Performance Standards, incorporated into EP III, now state that in “limited high risk circumstances” (i.e., when human rights violations are at a high risk of occurring), it may be appropriate for the EPFI (through their client) to complement its environmental and social risks and impacts identification process with specific human rights due diligence.

As well, specific labour standards due diligence is required for supply chains and contractors, particularly in the area of occupational health and safety, child labour and working conditions. Guidance for the conduct of such diligence is provided in the U.N. Guiding Principles on Business and Human Rights. These requirements overlap with legal and regulatory requirements on the same topics and may require legal advice in their implementation.

g.) Free Prior and Informed Consent

The new IFC Performance Standards require all high risk EP projects and those affecting Indigenous Peoples to implement a process of “Informed Consultation and Participation” and in some cases to achieve “Free Prior and Informed Consent” (“FPIC”) in relation to the project. The FPIC requirement is stronger than most national legal regimes and is drawn from international instruments like the United Nations Declaration on the Rights of Indigenous Peoples, which recognize that indigenous peoples must participate in the development of projects likely to affect them.

Implementing FPIC necessarily interrelates and overlaps with legal requirements regarding indigenous rights and consultation. This concept is ambiguous and controversial and its real meaning continues to evolve. The issue is particularly controversial and challenging in the Canadian context in light of Canada’s own constitutional recognition of Aboriginal rights and related laws regarding Aboriginal consultation.

 The implementation of FPIC by EPFIs is likely to be complex and will require careful consideration of these overlapping requirements.

II. Legal and Litigation Risks

There is clearly a business case for banks to follow EP III, particularly to address the reputational, legal and financial risks associated with their clients’ environmental and social performance.

However, by holding themselves out as overseers of their clients' environmental and social performance and publicly reporting on environmental and social compliance, EPFIs are exposed to legal risks beyond the inherent risks of project financing. Below we identify several of these legal risks and propose strategies to mitigate them.

a.) Legal Risks of Voluntary Agreements

The adoption of the EP is voluntary but, once adopted, EPFIs are committed to not provide certain financial services to clients who do not comply with the EP. They also commit to proactively carry out due diligence to ensure that their borrowers comply with the substantive requirements of the EP, which includes compliance with local laws, regulations and international best practices in environmental and social areas.

EPFIs must enter a formal agreement, called the Adoption Agreement, with the EP Association by which they undertake to adhere to the EP and EP Governance Rules. Among other things, EPFIs agree to insert additional contractual requirements into their financing documents binding on borrowers and to create and implement their own internal policies and procedures to screen and monitor their clients’ activities.

An EPFI makes public representations that this will be carried out by becoming a signatory of the EP and through public reporting on its implementation of the EP. Although adoption of the EP is voluntary, the “gratuitous undertaking” doctrine in Canadian law provides that a person can be held liable for a commitment they have voluntarily undertaken.

The doctrine arises from a class of cases that has long enforced gratuitous promises against persons who, having gratuitously undertaken some duty which induces another’s reliance, then negligently fail to perform that duty.

In Baxter v Jones, the seminal case in this area, the Ontario Court of Appeal held a defendant insurance agent liable for failing to notify the plaintiff’s insurance company of additional insurance that had been procured. The defendant argued that the promise to notify the insurance company lacked consideration and was therefore unenforceable. However, the Court of Appeal held that “it is well established that one who enters upon the performance of a mandate or gratuitous undertaking on behalf of another, is responsible not only for what he does, but for what he leaves unfulfilled, and cannot rely on the want of consideration as an excuse for the omission of any step that is requisite for the protection of any interest intrusted to his care.”

While the doctrine has been primarily applied in the context of gratuitous bailments and undertakings to obtain insurance, the doctrine has also been applied in several personal injury cases. There is no record of the doctrine having been applied in circumstances where an institution or individual has failed to adhere to a voluntary code of conduct, policy or industry standard like the EP, but the risk exists that it could be applied in such context, particularly where an EPFI is negligent in supervising project borrowers and ensuring that they comply with the EP’s environmental and social risk management standards.

b.) Lender Liability Risks

Lender liability may arise for EP projects taking place within Canada where environmental offences occur resulting in remediation or administrative orders. Such orders could extend to EPFI lenders if those lenders have the requisite degree of "charge, management or control" of their debtors' property or activities.

While such management and control is not typical in a standard arm’s length loan arrangement, an EPFI applying the EP could be found to exercise “charge, management or control” of a borrower’s development project through its audits and managerial oversight of environmental and social issues. Canadian courts have interpreted the terms “charge, management and control” in a broad and expansive manner.

This has allowed them to hold entities such as investors, receivers and mortgagees liable for environmental liabilities. Similarly, occupational health and safety laws may impose liability up the chain of ownership, including to those who have control over the workplace. In Canada in R v Sault Ste. Marie (City) , an independent contractor was hired by the city of Sault Ste. Marie to dispose of the city’s garbage. Although the city itself did not physically dispose of the waste in question, it was charged under section 32(1) of the former Ontario Water Resources Act.

The Supreme Court of Canada held that the city was liable because “it could have done more to prevent the contractor from polluting, particularly through the terms of the garbage disposal contract, and through its powers as a municipality.” In relation to the element of control, the court also stated that: “Liability rests upon control and the opportunity to prevent, i.e. that the accused could have and should have prevented the pollution...”.

  Since the Sault Ste. Marie decision, Canadian courts and the Ontario Environmental Appeal Board have held receivers, mortgagees, and investors liable for environmental contamination which they did not physically cause but could have prevented. Lender liability is therefore a very real risk for EPFIs that exercise control or influence over their clients’ projects and can withhold financing to enforce compliance with legal standards.

As well, it is possible that a borrower could fail to meet its obligations under the loan agreement, prompting EPFIs to carry on the project, at least for a time, as owner or operator. In either circumstance, if an EPFI ignores a borrower’s material breach of the EP, the EPFIs monitoring and auditing activities and remedial powers make liability for knowingly permitting, participating in or failing to prevent pollution a serious risk that could give rise to liability.

c.) Negligent Misrepresentations and Tort Liability

Even in the absence of specific regulatory requirements, there is a risk that failure to adhere to public commitments to conduct EP-related due diligence and ensure the compliance of borrowers and other clients could give rise to allegations of negligent misrepresentation or other tort liability, domestically or globally.

In Queen v Cognos Inc. , the Supreme Court of Canada identified five requirements to ground an action in negligent misrepresentation: (1) there must be a duty of care based on a “special relationship” between the representor and the representee; (2) the representation in question must be untrue, inaccurate, or misleading; (3) the representor must have acted negligently in making the said representation; (4) the representee must have relied, in a reasonable manner, on the misrepresentation; and (5) the reliance must have been detrimental to the representee in the sense that damages resulted. Critical questions in the EP context include whether an EPFI owes any duty of care (such as to affected communities) or whether such duties would be overridden by public policy considerations.

A case currently before the Ontario Superior Court could have a bearing on these questions and affect the potential legal risks of EPFIs. In a recent decision , the Superior Court allowed a trial to proceed in which the liability of a parent company for alleged human rights violations of security personnel employed by a subsidiary in a foreign jurisdiction will be considered. The plaintiffs claim that the parent corporation owed a duty of care to the affected community based, in part, on the corporation’s public statements that it had adopted voluntary standards, such as the Voluntary Principles on Security and Human Rights. In allowing the case to proceed to trial, the Superior Court considered the adoption of those voluntary standards as a factor that could affect the proximity between the parent company and the plaintiffs. If that argument is accepted at trial, the adoption of international codes of conduct like the EP could lead to an EPFI being found to owe a duty of care to communities affected by funded projects that the EPFI oversees.

While a lender is not directly analogous to a parent company, a duty of care could be found on the basis of adoption and implementation of a voluntary code to manage stakeholder risks. The final outcome of this case will be important to monitor for Canadian EPFIs.

d.) Third-Party Beneficiary Rights

Another potential legal risk for EPFIs arises from liability to potential third-party beneficiaries such as employees, unions, local communities or other stakeholders. Privity of contract would generally preclude non-parties to a financing agreement from seeking redress for EP III commitments from EPFIs or their borrowers. But, viewed in the context of third-party beneficiary rules in common law jurisdictions like Canada, privity of contract may not protect EPFIs from suits by individuals in communities affected by a project under EP III.

In Canada, a third party can obtain the benefit of another party’s contract where two criteria are met. First, the parties to the contract must have intended that the third party would benefit from the contract. Second, the actions of the third party must relate to the very activity contemplated by the contract. This exception to the normal rules of privity has been successfully invoked as a defence, to allow employees to benefit from their employers’ limitation of liability clauses and to allow successors to an original covenantee to rely on and enforce the benefit of perpetual contractual covenants given by the original covenantor.

The Ontario Superior Court of Justice has acknowledged that this exception is not restricted to defensive provisions, but warned that it would “take very clear language to find that a contracting party has assumed a liability to a third party, particularly where that liability is potentially unlimited.” It remains an open question whether EP commitments by an EPFI would provide the “very clear language” necessary to establish such a right in Canada. This is likely to be determined on a case by case basis and the availability of such a claim will likely turn on the contractual language used to entrench EP covenants into the project documentation.

III. Strategies to Mitigate EP-Related Legal Risks

These legal risks are important for EPFIs and their counsel to understand and to address in implementing their EP III commitments. To this end, we offer the following strategies for consideration.

  1. Utilizing legal counsel in conducting ESIAs (and independent reviews of the ESIA, as required by the EP) to ensure that legal diligence is done correctly with professional liability coverage and with the application of legal privilege. Surprisingly, many EPFIs are continuing to utilize engineering consultants to conduct legal due diligence despite the expanded scope of issues and emphasis on legal due diligence in EP III. This practice exposes the EPFI to unnecessary risks that can be remedied simply by identifying and retaining an appropriate advisor for the job;
  2. Revising contractual language that may give rise to third-party beneficiary rights in EP-related contracts to ensure that third-party beneficiary rights are expressly excluded and to reduce the possibility that there is an inference of such rights should a claim be made (although this will not protect against claims raised under the Adoption Agreement and will have to be done with regard to legal limits in existing (rather than new) agreements);
  3. Considering how past agreements can be revised to address legacy liabilities or the risk that third parties may have rights to enforce EP commitments under contractual terms, taking into account limitations that may exist in law on the removal of established third-party rights;
  4. Using indemnities to shift any monetary consequences of third-party claims from the EPFI onto borrowers, who are ultimately intended to be responsible for managing environmental and social issues;
  5. Ensuring internal legal oversight of due diligence processes, public reporting, stakeholder engagement and consultation activities, to ensure litigation risks are effectively managed. Again, this is about selecting the right external advisors and not just doing what was done on the last deal when the risks today may be very different; and
  6. Preserving and applying (where appropriate) legal privilege, mindful of the interest of transparency that is integral to the EP’s purpose, to prevent internal compliance assessments from forming the basis of future regulatory prosecutions or lawsuits. EP III marks a new era in the application of international environmental and social standards to project finance.

Understanding and acting proactively to address the legal risks associated with the application of the EP and the innovations inherent in EP III will be critical for EPFIs to mitigate these risks.

The above strategies, while not exhaustive, are intended to provide some initial guidance to Canadian EPFIs to assist in identifying any risk exposure they may face under EP III or its predecessors and considering potential steps to mitigate those risks.

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