Bank rating clauses, a blessing or a curse in Project contracts?

This article about bank rating clauses is the first in a series about the specificities of bank guarantees in the Project Businesses (Construction & Infrastructure, Oil & Gas, Power & Renewable, Utility projects etc). You may be interested in the other articles in this series and can find them easily by clicking here.

Context

In order to be sure that bank guarantees are issued by sufficiently solid banks, the contractual provisions often include wording on the rating of the issuing banks. This is especially true for project finance, where the Lenders are particularly concerned about the performance of the main contractor, usually working on an EPC basis.

A typical example of such bank rating clauses is as follows:

“Acceptable Bank” means a commercial bank which has an international rating (long term credit rating) with S&P of at least A or equivalent with Moody’s.

In case of any decrease in the rating of the bank issuing the Performance Security, the Contractor shall substitute the Performance Security with a security issued by an Acceptable Bank.

What are the advantages of such bank rating clauses?

The above example seems reasonable and straightforward. By this wording, the Employer is guaranteed not to get a bank guarantee that he is not comfortable with. The Lenders in a non-recourse Project Finance, have to make sure that the Contractor building the financed asset is as secure as possible. Getting sufficient and solid bank guarantees is really helpful.

Furthermore, there is objectivity attached to it as the ratings of the banks are easily accessible by both Contractors and Employers. This should avoid any discussion about the acceptability of a bank. Great, an easy one. A “no brainer” as we are used to say. Or not so?

What could be the curse of bank rating clauses?

Let’s have a deeper look at the issue. The purpose of a bank guarantee, such as a Performance Guarantee, is to secure the performance by the Contractor. In case the Contractor fails (i.e. is in material default), the Employer has the possibility to reduce its exposure to the Contractor by drawing on the bank guarantee. Most of the time, we are talking about an on-demand bank guarantee. More on this in another post.

Now, by that typical wording, the situation is somehow reversed. The Contractor starts guaranteeing the financial health of the issuing bank over the entire contract execution period. Is a Contractor supposed to do that? In the next chapter, we will see some do’s and don’ts on this subject.

What is the right thing to do when it comes to bank rating clauses?

Let’s sum up the legitimate interests of all parties to a contract in the Project Businesses:

• Employers (and their Lenders in a Project Finance) have a legitimate right to make sure they are getting quality bank guarantees (at the time they are first provided). The easiest way to achieve this is to foresee contractual wording checking the situation before actually issuing the bank guarantee. Making reference to “first class international banks” is usual practice. Including some preselected, acceptable banks in the contract language is also OK. The time between negotiating and signing the contract and the issuance of the bank guarantees is very short anyway.
• By their complexity, projects take a couple of years to be completed. And bank guarantees cover the entire project execution period (and often also the warranty period). Even the most reputed financial institutions, can get into trouble over such a period of 3, 5, 7 or more years. Does Lehman Brothers ring a bell? Contractors are not responsible for, and have no influence on, any changes in the issuing bank’s rating.
• While the downrating of a single bank is an unfortunate event, it can easily be handled, in agreement between the Employer and Contractor, by giving some time to the Contractor to replace its bank guarantees. It will probably have no impact on the bank guarantee costs. Remember, bank guarantees are only for special cases of specific, material lack of performance by the Contractor. It would be an unfortunate coincidence that this would be in parallel with the downrating of that bank. But, if that happens, well, I suppose it is fair for the Employer to call the bank guarantee out of precaution to avoid further exposure.
• When the entire financial market gets into trouble (downrating of several major banks in parallel), the situation becomes more complicated. Especially in such a situation, banks should hope to avoid a “run on the bank” situation. This would happen when bank guarantees have to be replaced under most of the Project contracts simultaneously due to a toxic market practice, i.e. the rating mechanism. Automatic replacement of bank guarantees, in case of a rating change, should therefore be avoided.

While Lenders (often commercial banks in Project Finance) should be cautious to push their Clients, the Employers in this case, into a toxic situation, we all know that Project contracts are negotiated individually, one by one. It is therefore the responsibility of a large number of dispersed Project negotiators to act reasonably. We hope the above explanation can help the project stakeholders – Employers, Lenders, Contractors and Law Firms – to find reasonable solutions. In the negotiations I’ve been involved in, the Lender’s (of a Project Finance) internal risk review committees were the hardest to convince. But, with creativity, patience and persistence, we managed to negotiate something acceptable for all parties.

Are we missing something? If yes, please let us know by commenting below.

Conclusions

While the first reaction to bank rating clauses is, “yes, it’s a good thing and even a must have”, it is important to look deeper into the subject. When looking at an isolated project, it seems a good thing to do. The situation is very different when it becomes a market practice.

When bank ratings degrade due to an economic downturn or a banking crisis, such rating clauses can worsen the situation. It may come to a “run to the bank” kind of situation where a large number of Contractors could be forced to replace their bank guarantees on very short notice in the midst of a volatile market. If they don’t succeed, their contracts may be terminated. And this for circumstances which are entirely beyond their control… As can be understood from the arguments in this article, we are not favorable to simple rating clauses.

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