Economic development and privatization in Latin America have led to increasing numbers of infrastructure projects. For most of 1998, confidence in the region was generally high, with many of the largest project finance transactions being structured without insurance against political risks. However, the Brazilian devaluation and a perceived change in Latin America's economic fortunes have highlighted the risks that lenders and sponsors face.

Political risks

Political risks can be significant. Historically, nearly every Latin American country has experienced an era of significant nationalization and expropriation. Latin American central banks generally have substantial discretion to restrict or prohibit the purchase of foreign currencies in their jurisdiction. They have intervened in foreign exchange markets to achieve exchange rate and other policy objectives. There are a variety of ways in which lenders and sponsors in a project finance transaction can obtain protection from political risks. One way is to obtain political risk insurance or similar protection from third parties, including: Opic, Miga, private insurance companies or government sponsored credit agencies.

Each provider of political risk protection has its own rules. Opic provides insurance against risk of inconvertibility of local currencies into US dollars, loss of investment due to expropriation, nationalization or confiscation, and loss due to war, revolution, insurrection or civil strife. Other entities provide insurance against inflation and currency fluctuations as well.

Political risk insurance is expensive. However, insuring against such risks as war, expropriation and currency inconvertibility can reduce the all-in cost of the financing. Given the high yields demanded by the market, many sponsors of Latin American projects will find it necessary or economically advantageous to obtain political risk insurance.

Protection from political risks can be obtained in other ways. In appropriate cases, monoline insurance companies stand ready to provide financial guarantee insurance to ensure timely payment of principal and interest. Bonds with an insurance wrap of this type will generally carry a AA or AAA credit rating, thus reducing the cost of financing. When the insurance policy is provided by an insurance company based outside Latin America, the practical effect is to guarantee against political as well as credit risks.

Private sector financial guarantee insurance can be used to facilitate placement of project bonds in domestic and international capital markets. Recent project financings in Chile show the potential impact of such financial support from monoline bond insurance companies. For example, the privatization and expansion of the Arturo Merino Benítez International Airport in Santiago, Chile, is being undertaken in large part with the proceeds of project bonds sold in the US capital markets in a Rule 144A bond offering. The bonds were marketed with an AAA credit rating as a result of a bond guarantee insurance policy issued by a US monoline insurer.

Foreign investment laws in Latin America may also provide protection from the political risk of a change in rules relating to currency convertibility. For example, non-Chileans making direct equity investments in Chile may enter into a foreign investment contract with the government. This guarantees the investor access to formal exchange markets to distribute profits and make subordinated loan payments to the investors, secondly a guaranteed rate of income tax on remittances of profits for a fixed period, and thirdly, non-discriminatory treatment relative to Chilean investors. This contract may not be unilaterally amended or terminated by the Chilean government without payment of damages. In the case of cross-border financings, access to Chile's formal exchange markets is ensured by registering qualifying financings with the Chilean Central Bank.

Finally, project companies that earn revenues outside their own country can avoid currency inconvertibility by holding funds offshore in designated foreign currency accounts.

Currency risks

Currency fluctuation is one of the principal risks facing foreign sponsors and lenders in Latin American project finance transactions. A decline in the value of a local currency can endanger a project company's ability to repay its foreign indebtedness and significantly reduce a foreign sponsor's return on its equity investment.

One way to minimize the risk of currency fluctuations is to obtain all or part of the financing for a project in the host country. The expansion of financial institutions and capital markets in Latin America should lead to increased local financing of projects.

The risk of currency fluctuations can be hedged through the use of foreign currency swaps. However, long-term swaps in Latin America have recently been too expensive to be a practical means of providing long term protection. Since lenders will generally be unwilling to accept any risk of currency fluctuation, project companies and their sponsors often have no choice but to bear it themselves.

However, the Chilean government has recently initiated a programme allowing foreign investors to enter into exchange rate insurance contracts that provide protection against exchange rate variations outside an agreed bond.

Security interests

One of the principal questions facing any lender to a project in Latin America is how to secure its interest in collateral located there. In civil law jurisdictions, the laws governing the creation of security interests are often based on codes not well suited to the implementation of modern financial structures. In Chile, for example, creditors are generally not permitted to take possession of movable and other assets in which they have a security interest. In the case of a foreclosure on a security interest, Chilean law provides for the sale of the asset and distribution of proceeds to secured parties and other creditors. This form of remedy can be of limited use in a project finance transaction, where creditors often prefer to obtain possession of project assets and the ability to manage a project, rather than simply to sell them off.

As in other Latin American jurisdictions, Chilean laws generally prescribe specific forms of security interests that must be used depending on the type of asset in question. But the prescribed forms are sometimes incompatible with the collateral arrangements that would otherwise best suit the situation. For example, in Chile it is not possible to create a security interest in a bank account. So it must be done in cash in the account, as though the cash were a form of movable property, and one must periodically register the cash amount that flows into the account. This type of security interest has not, however, been tested in Chilean courts. Also, under Chilean law it is generally not possible to conditionally assign a contract that is deemed to be ?personal?, such as a service contract. In the context of project finance transactions, it is not always clear how this prohibition applies. For example, there is no clear precedent on whether a Chilean court will enforce a conditional assignment of a project company's rights against a contractor under a construction contract or under performance guarantees.

Each type of security interest under Chilean law has formal requirements to create the security interest, maintain it and foreclose on it. For example, some forms of security interest cannot be used to grant senior as well as junior liens on the same asset.

Creditors' rights and remedies

The requirements and procedures for commencing and conducting a bankruptcy, liquidation or foreclosure proceeding under Latin American civil law systems can vary considerably. These rules are generally less developed and less tested under Latin America's civil law systems than in common law countries such as the US, the UK and Canada.

Although a full review of these issues is beyond the scope of this article, it is worth noting a few illustrative aspects. In Chile, for example, certain types of companies are technically required to petition for their own bankruptcy if they fail to repay certain types of debt. This raises the possibility at least (the practical implications of which are unclear) that if a project company has a dispute about a debt and is unable to settle it for any reason, it will be forced to petition for its own bankruptcy.

Second, in order to foreclose on a security interest or petition the bankruptcy of a debtor, Chilean law requires that the petitioning party obtain a judgment in its favor in an acción ejecutiva (an ?executive action?), which requires the party to have a título ejecutivo (an ?executive title?) such as a promissory note or a final judgment rendered in a Chilean court. Obtaining a final judgment can take several years. By the time such a judgment is received, the assets in which a security interest has been granted might have little value. So it is important in project finance transactions that creditors be delivered executive titles in case it is necessary to make a foreclosure or petition for the bankruptcy of a debtor.

Access to local capital markets

Increasingly, projects throughout the world are being financed on a project finance basis through capital markets rather than traditional bank and similar financings. This trend has begun in Latin America as well, as its capital markets have grown and become more sophisticated. However, the issuance of securities to fund projects this way generally entails a number of complex legal and other issues that must be resolved in conjunction with local regulatory authorities.

During the 1990s, many Latin American countries revised their securities laws to make them more disclosure-oriented, as in the US. However, in many cases these laws continue to be rooted in their civil law tradition, in which the principal object of the laws is to protect investors through the establishment of minimum substantive requirements applicable to publicly issued securities. For example, these laws may specifically require that issuers make certain types of covenants to bondholders, such as covenants to limit indebtedness. Chilean securities laws mandate that proceeds from securities publicly sold to fund start-up projects must be deposited with a custodian who manages the funds in accordance with specific rules. These requirements can limit a sponsor's flexibility to structure an offering and devise practical mechanisms to regulate the disbursement of proceeds.

Laws defining the investment authority of local pension funds and insurance companies often have the practical effect of precluding such institutions from investing in project financings. One method used successfully in recent transactions is to provide external credit enhancements for a project company's debt, thereby meeting local eligibility requirements. Such credit enhancements may include financial guaranty insurance, letters of credit and construction completion guarantees. However, importing tested transaction structures for offerings of credit-enhanced debt securities into local Latin American capital markets can require significant ?legal engineering? to accommodate local securities and other laws.

Access to capital from multilateral institutions

In light of the recent turmoil in emerging markets, multilateral development banks, such as the International Finance Corporation, the Inter-American Development Bank and Corporación Andina de Fomento, can be expected to play an enhanced role in Latin American project financings. The closing near the end of 1998 of financing in excess of $2 billion for the Brazil-Bolivia cross-border pipeline is a clear indication of the importance of foreign banks and multilaterals as providers of capital in periods of difficulty.

Of course project financings are by nature complex transactions and often involve multiple sources of debt and equity funding, as well as political risk insurance, financial guarantees, hedging arrangements and other credit and liquidity support, from a variety of public and private sector institutions from various jurisdictions. Accordingly, even with the strong presence of one or more multilateral development institutions, intercreditor issues pose a significant challenge aside from the basic terms of the borrowing between the project company and its lenders.

Despite its complexity, project finance has proven to be an important source of funding for major infrastructure projects in Latin America. This trend should not only continue but accelerate, as will the need for careful attention to the legal aspects of such transactions.

Robert Gibbons and Ivan Mattei are partners at Debevoise & Plimpton. Michael Hartman is an associate at Debevoise & Plimpton in New York.