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The Warsaw Voice » Law » February 6, 2008
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Cost Overrun Guarantee: Where is the Devil? As Always, in the Details.
February 6, 2008   
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Putting the label "guarantee" on this device may flatter to deceive. Having come across regular guarantees, you might think a creditor could get some direct benefits from a cost overrun guarantee. Sorry to disappoint: the benefits are indirect.

Cost overrun (CO) guarantees are used in project finance as a quasi-security device for the benefit of banks providing finance. Since cost overruns are not usually a bank risk, they are passed on to project sponsors (direct or indirect owners of the project company) which, acting as "guarantors," undertake to cover costs that were unforeseen at the original budget planning stage. The underlying idea is to protect investments made by the banks, which take a large part of the risk for completion of the project, as they seek a return on their investment from the profits eventually generated by the project.

As CO guarantees are not regulated directly by law and their content largely depends on the particular business deal, there is no standard document as such to work on. However, there are certain common elements. A CO guarantee is usually a three-party agreement between the financing bank as an indirect beneficiary, the project company as a direct beneficiary, and the project sponsor acting as a guarantor. The sponsor gives the bank and the project company a guarantee that it will support the project in the event of cost overruns. The upshot is that the bank can require the sponsor to give the project company funds to cover extra costs. Naturally, the project company may demand a capital injection on its own, but, since it is controlled by the sponsor, the security lies in granting this right to the bank to protect it against a sponsor abandoning a difficult project to the detriment of the bank.

Typically, a CO guarantee states that the payment shall be made unconditionally on the first demand of the beneficiary. The payment obligation depends on more than a mere presentation of a demand to the guarantor, as in a typical first demand bank guarantee. Actual cost overruns have to arise and be proved. Hence, cost overruns have to be defined exactly in the guarantee and a mechanism provided for a quick and objective assessment of whether any have arisen. Typically, they are defined as additional project costs which, at any one time, are in excess of the original costs budgeted for that stage. The assessors will usually be either the project company, or the bank supported by an independent technical advisor.

Unlike a regular corporate guarantee or surety, the guaranteed payment would go directly to the project company, not the bank. Hence, it aims to prevent, not cover any financial indebtedness to the financing party. That is also a reason why payments under CO guarantees are not additionally secured by collateral in favor of the financing party. CO guarantees are also not to be confused with completion guarantees. Both provide additional assurance for the success of the project, but the guarantor under a completion guarantee (rarely used) essentially gives a blank check to ensure project completion.

From the legal perspective, one legal facet of a CO guarantee is that the relationship between the bank and the guaranteeing sponsor is characterized as an agreement for the benefit of a third party. As such, it falls under article 393 of the Civil Code with the result being that the project company may demand payment directly from the sponsor. The guaranteed amount paid is usually treated as an inter-company loan. The legal relationship between the project company and the bank is rather vague and is a mishmash of minor rights and obligations facilitating performance of the core arrangement between the guarantor and the bank.

Banks often ask about the real strength of a CO guarantee and what the consequences are for the guarantor if it refuses to pay. It is unsupported by any collateral, which impacts effective enforcement. The remedy against the guarantor is damages for non-fulfillment of the guarantor's obligation, which have to be substantiated. Specific performance is another remedy, but it is not commercially viable in project finance. On the other hand, the mere prospect of a massive remedy action by a bank (possibly combined with taking over the project) should act as a good enough deterrent. Also, damages for failure of the project will normally exceed any cost overruns. The major value of any CO guarantee, arguably, is that it reflects the common understanding of the parties that the sponsor will support the project and its successful completion, which also means assuming the risk of unforeseen costs.

Mateusz Toczyski, Krzysztof Kaźmierczyk
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