The legal due diligence process helps in identifying the key legal risks and provides for mitigation strategies.
The Indian infrastructure sector is one of the most significant drivers of the Indian economy. It is a cornerstone for India to reach its ambitious target of being a 10 trillion economy by 2030-35. The infrastructure sector includes various industries such as power (including renewables), oil and gas, roads and transportation, railways, ports, aviation, urban infrastructure, telecom, etc. Being a “public good”, infrastructure projects in India are regulated and sector-specific regulatory bodies have been established to administer the planning, development, and execution of such projects. Development and operation of projects typically requires various regulatory approvals and compliances. Infrastructure projects also involve various stakeholders – developers, lenders, EPC contractors, operation and maintenance service providers, offtakers and in the case of public procurement and/or PPP projects, the relevant government authority issuing the tender/granting the concession. Each of these relationships are governed by appropriate contractual arrangements. The projects are usually developed and operated by a special purpose vehicle company (SPV) incorporated by the project developer for implementing the project.
Mergers and acquisitions (M&A) in the infrastructure sector are therefore nuanced and, apart from the corporate, tax and anti-trust related issues, involve sector-specific risks. The legal due diligence process helps in identifying the key legal risks and provides for mitigation strategies. The identified risks and the related mitigants are appropriately incorporated in the definitive agreement(s) governing the acquisition, either as conditions precedent to the investment, conditions subsequent (typically with a hold-back/deferred consideration clause, as permissible under applicable laws), representations/warranties backed by general indemnity by the seller, or as specific indemnity matters. Prior to closing of the transaction, if there is a ‘material adverse effect’ on the project development, the investor must have the ability to terminate the acquisition agreement, without any consequences. The limitation of liability provision is also crucial and governs the overall liability of the parties. In fact, these clauses tend to be the most heavily negotiated clauses of an acquisition agreement. Warranty and indemnity (W&I) insurance may also be considered to mitigate the sector-specific issues and risks.
Some of the key legal risks involved in M&A in infrastructure sector include:
• Land Related Issues – In India, fragmented land parcels are widespread owing to socio-economic factors. This landscape intensifies the complexities surrounding the diligence process, impeding the identification of free and clear titles for the land parcels. Land records are disorganized or entirely missing from government archives. There are delays on account of government approvals necessary for changing land use patterns and obtaining exemptions from ceiling limits. It is also difficult to identify pending litigation and mortgages on identified land parcels, which directly impacts land ownership. Difficulties in obtaining right of way/easement rights over land where a ‘right of use’ is required for project construction/operation also pose a risk.
• Change in Control / Equity Lock in Restrictions – Project agreements may include equity lock-in restrictions, where the project developers are required to hold either controlling interest in the project SPV/or a minimum percentage of shareholding, either in perpetuity or for a certain number of years from the date of project commissioning. In such circumstances, prior approval from the contract counterparty will be required to waive such restrictions. The transferring party is required to demonstrate that the acquiring entity has the technical, financial and operational capability to acquire the project. Such restrictions are usually seen in concession agreements and purchase/offtake agreements where a government agency is a counterparty. Such restrictions are also seen in financing agreements, where lender approval is required for any change in shareholding/change in control. Any change in shareholding/change in control without obtaining approval is an event of default under the relevant contract, leading to termination/loan acceleration.
These sector-specific risks must be appropriately evaluated, and robust mitigating measures must be factored in the acquisition agreement.
• Restrictions on Assignment – Project contracts usually have restrictions on assignment of rights/interests arising out of the contract, without the prior written approval of the counterparty. Such clauses usually have an exception for assignment in favor of the project lenders. However, sometimes the restriction may be absolute, making the financing/re-financing of the project difficult. Assignment related restrictions and approvals are also relevant in asset transfer/business transfer transactions, where the contract may not automatically transfer by virtue of the acquisition and an assignment may be necessary.
• Cash-flow Issues – Regular cash-flow and payment security are quintessential for any bankable infrastructure project, to ensure timely debt-service, meet the long-term capital expenses and operating costs and to ensure a profit. Payment security clauses, whether in the form of letter of credit, interest on delayed payment, bank guarantee, escrow mechanism, etc., assume great significance. Inback-to-back contracts such as supply contracts and sub-contracts, offtake contracts where there is a further downstream sale (e.g., power purchase agreement and power sale agreement), the payment cycle and payment security clauses must be aligned to ensure adequacy of cash flows. Appropriate provisions for addressing delayed payment and disputed invoices are essential for ensuring prompt resolution of such disputes, and timely payments to the project developers. Additionally, from a developer perspective, the contracts must also have minimum offtake obligations and associated liquidated damages/take or pay obligations for failure to offtake.
• Project Delays & Consequences – Time is of essence in completion of infrastructure projects. There are substantive revenues and damages linked to the completion date and its delay, respectively. Delay in project completion has consequences in the suite of project contracts, where the developer is required to pay delay liquidated damages. Delays also affect cash-flows and debt-service and lead to cost overruns. Hence, the risk allocation during construction phase is critical and any damages during delay are typically passed on to the EPC contractor. The EPC contract must adequately cover for such risks, in the form of back-to-back liquidated damages for delay, performance guarantees, escrows and holdback clauses. Cap on delay liquidated damages and overall liability clauses also merit consideration. The developer should also have an appropriate contract management system, to ensure tracking of project milestones and timely completion.
• Performance Risks and Performance Damages – Performance related clauses in project contracts govern the liabilities of the EPC contractor/developer/operator with respect to the functioning of the project, ensuring accountability and mitigating risks arising on account of performance failures. Liquidated damages are typically payable for failure to meet the performance obligations. The EPC contractor is liable only till the defect liability period and after this period lapses, the performance risks are transferred to the project developer/O&M contractor. The consequences of failure to meet the performance guarantees, cap on liquidated damages and overall limitation of liability are important issues to consider.
• Force Majeure & Change in Law Risks – A vast majority of the disputes between the stakeholders in the Indian infrastructure sector are on issues relating to change in law and force majeure events. A ‘Change in Law’ clause, addresses mitigating risks linked to legislative changes and its impact on the contract price. A ‘force majeure’ clause addresses relief to an affected party (temporary suspension of performance of obligations) on account of events outside the party’s reasonable control, such as acts of God, war, etc. Payment related obligations are usually specifically excluded from force majeure relief. To mitigate the adverse impact of vexatious litigation, it is important that these clauses are well-drafted and are in line with market standards and judicial principles.
• Permits & Consents – Infrastructure projects require various statutory approvals and clearances at various stages of the project. These approvals cover a range of aspects, including land acquisition, zoning permissions, public utility access, safety approvals, forest clearances, hazardous waste management, usage of ground water, etc. Further, as infrastructure projects have a major impact on the environment, Indian environmental compliances and ESG reporting, and compliances assume great significance. Moreover, these statutory approvals and clearances may have certain terms and conditions to be complied with by the project SPV. The validity and adequacy of these approvals and compliance with terms and conditions by the project SPV are of importance.
• Insurance coverage – It is imperative to ensure that the project SPV has adequate and valid insurance policies in place to protect against risks during the construction phase and O&M phase.
These sector-specific risks must be appropriately evaluated, and robust mitigating measures must be factored in the acquisition agreement. In the event the investor is not acquiring 100% interest in the project SPV, and the project developer retains a stake in the project SPV, the inter-se rights and obligations of the investor and project developer are negotiated and documented in a shareholders’ agreement/LLP agreement/joint venture agreement. The events of default and exit mechanics in such an agreement should be drafted with utmost care, to ensure that appropriate recourse is available to a non-defaulting party in a scenario of default. Therefore, mechanisms such as such as put options, call options, drag/tag rights etc must be meticulously crafted. Other important clauses to be negotiated include the management rights, reserved matters, further funding obligations, restrictions on transfer, dividend policy and audit rights. The terms of the inter-se agreement should also be included in the charter documents of the Project SPV.
During the presentation of the current union budget, the finance minister delineated seven key priority areas of focus for the budget, and aptly termed them – ‘Saptarishi’. Notably, one of the key areas of interest is development of the infrastructure sector and investments in the sector. In line with the vision of the union budget, an amount of 10 lakh crore has been earmarked for the infrastructure sector, which is almost 3.3% of India’s GDP. Given the budgetary emphasis and policy reforms, the sector has witnessed a fillip in M&A activity and attracted foreign investments. Risk identification and mitigation strategies in infrastructure projects is critical to protect investors’ rights and boost investments in the sector.
Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.