Ensuring That Loan Documents Address Equator Principles and Trade Sanctions

Ensuring That Loan Documents Address Equator Principles and Trade Sanctions

April 01, 2014

By Yasser Yaqub, Gaurav Sharma and Richard Olive

New Equator Principles need to be reflected in loan agreements. Lenders and project sponsors should also protect themselves against increasing use of trade sanctions by
governments to enforce foreign policy goals.

The Equator Principles are a set of rules to which development financing institutions, export credit agencies and many large banks have committed to follow when deciding whether to lend. The lenders have agreed not to lend to projects that damage the environment or cause social turmoil. The principles have been recently updated.

Equator Principles

The Equator Principles Association launched the third version of the Equator Principles — called EPIII — in June 2013. While EPIII became effective on June 4, 2013, a transition period was introduced covering the remainder of the year.

Therefore, EPIII became mandatory for projects financed by financial institutions where the mandates were signed on or after January 1, 2014.

It is timely to consider how to incorporate the requirements of EPIII into loan documentation as the finance documentation for the first projects that are subject to EPIII is currently under negotiation. The Equator Principles Association updated its guidance in March on how to implement the Equator Principles in loan documentation.

EPIII has brought within the scope of the Equator Principles, project-related corporate loans and bridge loans in addition to project finance advisory services and project finance that were already covered. The project capital costs have to be more than US$10 million to be covered. EPIII has also put new emphasis on climate change, increased emphasis on human rights, expanded the reporting requirements of the financial institutions making covered loans and enhanced the covenants that are required in loan documentation.

When considering incorporating the Equator Principles into loan documentation, it is not usually enough merely to require the borrower to comply with, or not violate, the Equator Principles. This is because the Equator Principles are not a charter specifically directed at borrowers or sponsors but rather are a set of principles directed at lenders.

Therefore, the key is to take the Equator Principles and convert them into environmental and social compliance provisions that can then be incorporated into the loan documentation.

A project will first need to be categorized by the lender during its due diligence process according to the degree of environmental and social risk the project presents.

Project Categorization

The categories are:

  • Category A: Projects with potentially significant adverse environmental and social risks or effects that are diverse, irreversible or unprecedented.
  • Category B: Projects with potentially limited adverse environmental and social risks or effects that are few in number, generally site-specific, largely reversible and readily addressed through mitigation measures.
  • Category C: Projects with minimal or no adverse environmental and social risks or effects.

This categorization of the project will determine the requirements that the lender is likely to impose on the project. These will depend on the category.

Thus, lenders will have to assess the environmental and social risks and require the sponsor to put in place a system for managing such risks for category A and B projects. The sponsor will have to prepare an environmental and social management plan and also have a plan to address any environmental and social issues that do not comply with the relevant standards. An independent consultant will have to be hired to assess the adequacy of these plans. This is compulsory for category A projects and may also be requested for some B projects. The lenders will have to set up complaint and grievance procedures for local communities affected by the project. They must also consult with affected local communities. This is compulsory for category A projects and may also be requested for some B projects. Finally, the sponsor must turn in regular compliance reports to the lenders.

In order for a lender to ensure that the project to which it will be lending will comply with the Equator Principles, the above requirements will need to be tailored to the specific project based on the activity being undertaken by the project.

Financial institutions and sponsors can at times be ambivalent about the details of implementation of the Equator Principles after the loan has been funded, and such ambivalence can translate into provisions in the loan documentation that do not serve their intended purpose.

For instance, having representations and covenants simply to the effect that the borrower must comply with the Equator Principles betrays a lack of understanding of the regime set up by the Equator Principles Association.

Implementation of Equator Principles in loan documentation should typically be structured in the following manner.

The borrower should represent that there are no environmental or social claims or potential such claims against the project that might have a material adverse effect on the implementation or operation of the project.

There should be several standard “conditions precedent” to the initial disbursement of debt. No draw should be allowed until the borrower has obtained all necessary environmental and social permits (and provided opinions as to the completion of this requirement). The borrower should have appointed the necessary technical consultants to undertake an agreed scope of work. The borrower should also have delivered all reports, assessments and plans relating to the environmental and social impact of the project.

Conditions precedent may also be required for each future disbursement. Such conditions would typically require confirmation that the project continues to be in compliance with any applicable (at that stage) environmental and social requirements and that all actions required by any environmental and social management plan have been completed as required.

The borrower should be required to report to the lenders on environmental and social matters at regular intervals (usually on an annual basis during the operation phase and more frequently during construction). These reports will include preclosing reports, progress reports during construction and operational reports.

Any environmental and social claims, environmental contamination, health and safety violations, protests or grievances by the local community and project employees and any other environmental and social issues should also be reported to the lenders as they occur.

The borrower may also be required to make public reports on certain issues (for example, emissions reports where the project emits more than 100,000 tons of CO2 equivalent annually).

The borrower should be required to covenant to comply with the environmental and social requirements (including the environmental and social management plan), deliver progress reports documenting and certifying compliance with these requirements, allow access to the lenders and their representatives to assess compliance, conduct any decommissioning in accordance with a predetermined decommissioning plan and respond to complaints about construction, permitting and operation of the project. The borrower may also be required to agree not to amend the environmental and social management plan materially without lender consent.

While some lenders may insist on including events of default specific to environmental and Equator Principle compliance, such inclusions should not be required if the conditions precedent, representations and covenants outlined above have already been included. The loan documentation will already provide for lender rights of termination, subject to varying periods of remedy allowed to the borrower, upon the breach of such representations and covenants.

Trade Sanctions

Trade sanctions can be imposed by various intergovernmental organizations and states. The United Nations Security Council can impose sanctions that are binding on all UN members while the European Union issues sanctions directly effective in all member states. Individual countries such as the United Kingdom and United States also impose sanctions that are usually tougher in terms of scope and restriction than sanctions imposed by the UN and EU.

While trade sanctions can take a number of forms, the most relevant types of sanctions for parties in project financing are financial sanctions. Under certain sanctions regulations, financial institutions are prohibited from making available any funds, other financial assets or economic resources to sanctioned entities or sanctioned countries. This could include the release of money in a bank account to an account-holder or extending a loan or guarantee to a client who is linked to a sanctioned party.

Breach of financial sanctions may be considered a criminal offense punishable by imprisonment, a fine or both. A number of financial institutions have been subject to multi-million dollar fines and settlements with the US and UK regulators for sanctions breaches.

In the US, the Office of Foreign Assets Control or “OFAC,” which is part of the US Department of the Treasury, administers and enforces financial sanctions. The US Treasury maintains jurisdiction over all US dollar transactions, and its aims are to ensure no sanctioned countries, entities or individuals engage improperly in US dollar-denominated transactions.

OFAC is extremely proactive and diligent in enforcing US policy and has implemented regulations that have extraterritorial reach to the activities of foreign financial institutions. In 2009, a UK bank agreed to pay a US$350 million penalty in lieu of US criminal prosecution for processing payment transactions made by its clients through unaffiliated US banks.

Although the bank was technically not a US entity and none of its process payment transactions took place within the US, its actions caused its unaffiliated US correspondent banks to breach OFAC regulations and, therefore, its actions were caught by the US sanctions regime. More recently, in 2012, another UK bank paid approximately a US$300 million fine for concealing transactions through the US financial system primarily on behalf of Iranian and Sudanese clients by removing information that would have revealed the payments and otherwise would have been rejected, blocked or stopped for investigation under OFAC regulations.

Given the challenges of complying with overlapping sanctions regimes, and the potentially significant penalties and personal liability for breaches of regulations, financial institutions need to be conscious of the complexities of sanctions laws.

It is important in any project financing that lenders are aware and protected from their funds being used for any sanctioned activities. Borrowers also need to manage risk to ensure they are not inadvertently prejudiced should another party to the project finance agreements breach the relevant sanctions regulations.


As a matter of policy, lenders will include a series of sanctions-related representations coupled with undertakings in the loan documents so that in the event their funds are used in any type of sanctioned activity, the lenders will have recourse against the borrower.

Trade sanctions may be imposed for use of funds directly or indirectly in a sanctioned activity. This includes dealing with persons or entities designated on a particular sanctions list or carrying out transactions in sanctioned countries.

Therefore, when negotiating a sanctions representation, lenders should insist on not only capturing the borrower under the scope of any representation, but also any party to whom the facilities can potentially reach.

For this reason, it is not uncommon to see sponsors, shareholders, the EPC contractor, the O&M contractor and guarantors covered by the sanctions representation. While the borrower will obviously want to limit the inclusion of other parties, the borrower may be more receptive to having the scope cover the additional parties if it is able to obtain the same level of protection from the additional parties under its contractual documentation with such parties.

Lenders will want the borrower to covenant that the sanctions representation will remain true at all times until the loan is fully repaid.

Typical representations in relation to trade sanctions include that the borrower and other related parties have not made the proceeds of the facility available directly or indirectly to any person or entity that is sanctioned or affiliated with a sanctioned entity and have not made any proceeds of the facility available for use in a sanctioned country. The borrower may have to represent that neither it nor any related party is a sanctioned entity or has violated any sanctions and it is not aware of any claim or investigation against the borrower or an affiliate by a sanctioning authority.

The lenders should also require negative covenants relating to sanctions where the borrower and related parties undertake to refrain from certain actions. There should usually be a prohibition on the borrower and related parties from making any proceeds of the facility available to any sanctioned person or for use in a sanctioned country for the purpose of financing activities in breach of the sanctions.

If the borrower breaches a representation or covenant in the loan agreement, then it should be entitled to a certain number of days within which to remedy the sanctions breach before the lenders are able to call an event of default. Conversely, if the borrower breaches a negative covenant, then the lenders may insist on no remedy period so that the lenders have the right to call an immediate event of default.

Should a party other than the borrower breach a sanctions provision in the loan agreement, then apart from any remedy period available, the borrower’s only recourse should the lender call an event of default is to claim against the other party in breach of the sanctions provision under its contractual framework with that party. This highlights the importance of the borrower properly allocating its risk and ensuring that it is covered directly for breaches of parties outside its control.

Remedies available to the lenders should the borrower or a related party breach a sanctions representation or covenant include calling an event of a default, allowing the lenders to cancel the loan agreement and facilities under it and claiming immediate payment of any funds drawn down by the borrower.

Against the backdrop of existing anti-money laundering and anti-terrorist financing laws, financial institutions must not overlook the growing area of sanctions law and how to protect themselves in project financing agreements. From a borrower’s perspective, the project and finance documentation should include coverage for breach of the sanctions provisions by other project parties.