Collateralisation of project finance: The process of perfection of securities

On track with its aim of laying the necessary groundwork for foreign businesses, the emergent tourism industry and progression in living standards, Bahrain is viewed by many as an ever-evolving country. Major infrastructure and industrial projects are being undertaken across the Kingdom. Bahrain Bay, a $2.5bn landmark waterfront community located off the north shore of Manama, is one prominent example. Pronounced the “Best Mixed-Use Development in the Middle East” at last year’s International Property Awards, Arabia, the project has gained worldwide recognition. Durrat Al Bahrain, a resort island city created across a cluster of 15 islands on the south coast of Bahrain, is another such example.

With all these observations, it is but natural to wonder how these multi-million, and sometimes multi-billion, dollar projects are financed. And even more importantly, what security does a financier have in the event the project fails? These questions are more important in light of the global recession and its adverse impact on local business, which in turn increases the likelihood that major projects may fail. Commonly used terms such as “project finance”, “collateral” and “security” come to our mind, but few know exactly how they function in, sometimes, a web-like correlation between the parties involved.

PROJECT FINANCE: Simply put, finances extended as loan facilities for projects are called project financing or project finance. A project is first conceived by its founders. These founders are the equity investors, also known as sponsors of the project. More often than not, these sponsors have limited financial means and can invest only a small portion of the entire capital required for the construction, development and operation of the project. The question then arises as to who injects the remaining capital required. This is where the banks and other financial institutions come to play their much-needed role as lenders. If it is a large-scale project, a syndicate of lenders pool their resources to extend the requested finance facility so as to share the financial liability and the associated benefits and risks. Small projects, on the other hand, are usually financed by a loan from a single bank or other financial institution.

Each project gives rise to its own risks and, hence, poses its own unique challenges. Those advising on project financing need to act creatively to meet the challenges and efficiently minimise risks. Full recovery of the extended finances, along with the profit or interest returns, remains a primary concern. Therefore, a closely associated concept of security or collateral plays an integral role in all project financing.

SECURITY OR COLLATERAL: A security or collateral is a safeguard or remedy available with the lender in the event the borrower fails to honour its obligation to repay the obtained finance facility. As and by way of security for the repayment of the extended finance facility, a charge is created over assets of the project and/or the sponsors in favour of the lender. Terms like mortgage, pledge, hypothecation and lien are different forms of encumbrances created over varying assets used as collateral. These collaterals may be further supplemented by individual, corporate and sovereign guarantees and assignment of rights. In the event the borrowing project company defaults in its payment obligations, the lender is generally entitled to liquidate those charged assets and settle its claims from the proceeds so realised. However, this is often easier said than done.

In practice, questions like which collaterals are generally used for securing lenders in a given jurisdiction and what procedures are involved for the perfection of such collaterals are pivotal from the inception of any project. This is so because only a perfected security or collateral can be enforced by the lender to satisfy its claims prior to the satisfaction of claims raised by the unsecured parties against the borrower.

The term “perfection of security” has no defined statutory or judicial meaning. It is a concept that may vaguely refer to the procedural steps required to ensure the security interest is enforceable in favour of a creditor. Therefore, perfection of security interests means different things in different jurisdictions. Creditors in whose favour a security interest has been perfected are known as secured creditors. In the event of liquidation of a security asset, secured creditors take priority over those creditors in whose favour security interests have not been perfected. In other words, the liquidation proceeds are, generally, first applied to satisfy claims of the secured creditors and the remaining amount is directed to unsecured creditors.

Generally, one or more of the following collaterals or securities are created to secure repayment of project financing in Bahrain. LAND/BUILDING MORTGAGE: This is a security whereby the owner of a piece of land or a building creates a charge over that land or building in favour of the lender. In the event of default, the lender is entitled to sell the mortgaged land and apply the proceeds so realised to settle the outstanding amount due and payable by the borrower. This entitlement is subject to the applicable enforcement procedure. To evidence the creation of a mortgage, a written agreement, drawn up bilingually (in Arabic and English) or in Arabic, is executed by the parties before the Notary Public. The notarised agreement is then registered at the General Directorate of Land Registration, Survey and Land Registration Bureau.

BUSINESS MORTGAGE: Compared closely with hypothecation in some jurisdictions, a business mortgage is a charge over a “place of business”, which generally extends to cover a collection of tangible and intangible assets. These assets may in particular include, goods, furniture, industrial machinery, contracts with customers, goodwill, trade name, lease rights, intellectual property rights and licences. A business mortgage does not, however, include immovable property. In the event these assets are not expressly stated in a written agreement, a mortgage over a place of business would, by default, only include trade name, lease rights, contracts with customers and goodwill of the business. To evidence the creation of a business mortgage, a written agreement, drawn up bilingually (in Arabic and English) or in Arabic, is executed by the parties before the Notary Public. The notarised agreement is then registered at the Ministry of Industry and Commerce for a period of five years, which may thereafter be renewed. From a practical perspective, all parties with whom any contracts have been entered into are notified of the business mortgage and their acknowledgement is sought in respect thereof. In addition, a summary of the business mortgage is also published in a local newspaper for perfection of this security.

SHARE MORTGAGE: This is a security whereby a charge is created over the designated shares in the capital of a company along with rights over dividends and other benefits attached to such shares. However, the secured party does not have a right to attend shareholders’ meetings or participate in shareholders’ resolutions. Different rules apply for perfection of this security depending on the type of company.

• Bahrain Public Joint Stock Company: Mortgage of shares in a Bahrain public joint stock company is created by way of a written agreement and perfected upon its registration in the Central Securities Register at the Bahrain Bourse.

• Bahrain Closed Joint Stock Company: In relation to the shares in a Bahrain closed joint stock company, a written agreement, drawn up bilingually (in Arabic and English) or in Arabic, is executed before the Notary Public. Subject to the provisions of the constitutional documents of the company, the share mortgage is registered in the share register maintained by the company. While not a legal requirement, it is highly recommended that the notarised agreement is registered at the Ministry of Industry and Commerce.

• Limited Liability Company and Single Person Company: A mortgage over shares in a limited liability company and a single person company is created by way of a written agreement, drawn up bilingually (in Arabic and English) or in Arabic, and executed by the parties before the Notary Public. There is a legal requirement to register such a share mortgage with the Ministry of Industry and Commerce.

CHARGE OVER BANK ACCOUNT: This is a security whereby a floating charge is created in favour of the lender over any amount standing in a designated bank account. In the event of default, the floating charge freezes over the amount in that bank account. The bank in which the account is maintained is then notified of the charge and its acknowledgement is obtained as a pre-condition of the security.

Apart from the execution of a written agreement to evidence the creation of a charge and the said notification, there are no other formality requirements for perfection of this security.

ASSIGNMENT OF RECEIVABLES: This is a security whereby all present and future rights in receivables (in other words, claims that are expected to be collected or received) in connection with the project are assigned in favour of the lender. All parties from whom receivables are expected are notified and their acknowledgement is obtained as a pre-condition.

Apart from the execution of a written agreement to evidence assignment and the said notification of assignment, there are no other formal requirements for perfection of this security.

GUARANTEE: A commonly used term, guarantee is a security whereby the guarantor assures the lender that the borrower’s payment obligations in connection with the finance facility will be duly discharged by the guarantor in the event the borrower fails to do so. Apart from the execution of a written agreement to evidence guarantee, there are no other formal requirements for perfection of this security.

SECURITY AGENT: If the project is located in Bahrain, in most likelihood, assets to be secured in favour of lenders for project financing will be located in Bahrain too. This presents a problem if there are overseas lenders who are not physically present in Bahrain for enforcement purposes. In such situations, it is common for foreign lenders to appoint a local financial institution, generally a bank licensed by the Central Bank of Bahrain, to act as a security trustee or agent on behalf of the lenders. All securities are created in favour of the security agent who holds them for and on behalf of lenders. Security agents are also appointed in case there are multiple lenders.

WEIGHING UP SECURITIES: Thus, collateralisation is an intricate process, in that a lot goes into the pot before lenders can be assured that their interests are adequately protected in the most cost-effective and efficient manner. Securities that require registration for their perfection are weighed between their registration charges, their relative ease and associated cost of enforcement, and the level of protection they guarantee to the lenders.

Enforcement of one security may be slightly less burdensome than another. For example, enforcement of charge over bank account, assignment of receivables and guarantee may be a relatively straightforward procedure compared to enforcing land, business or share mortgages, which can entail both a lengthy and convoluted process. Yet, the value of land, business or shares may be significantly higher than all other securities combined. In the end, all such commercial considerations must be seen in light of anticipated legal and procedural hurdles.

MAKING A CHOICE: It is these factors that tip the balance in favour of one form of security over another. What convinces the lender to extend a finance facility is an assurance that, irrespective of the project’s success or failure, the project finance provides a win-win situation for the lender. To this end, the advisors prepare tomes of documents to record the rights and obligations of the parties. Up until all the obtained finances have been repaid by the borrowing project company, these lenders – playing their back-stage role – have a lot more power than what the owners of these large-scale projects are thought to possess.