Setting energy balance

19.02.21

The proverbs ‘discretion is the better part of valor’ and ‘fast friendship ends in a long enmity’ probably have analogues in most countries of the world. Due to its universality, they are relevant in different contexts, including business.

In practice, however, they are often forgotten. The reasons may vary from the seemingly high attractiveness of the investment project to personal friendship of future partners. Positive experience in similar projects in Ukraine or in other jurisdictions may also be a factor.

And in some cases, projects that are legally poorly structured actually work well as a business due to a number of positive factors. However, often it happens the other way around when risks that were not initially taken into account often lead to significant losses in subsequent stages.

Energy projects are among the most sensitive to careful structuring. The implementation thereof is time-consuming and depends on many legal, economic, technical and regulatory factors. Moreover, such projects can be sensitive to changes in the political climate of the country, as the experience of renewable energy over the past year has shown.

These aspects determine the structure of the transaction and the agreements between the parties. The more detailed the parties agree upon agreements at the start of cooperation, when everyone is ready to work constructively, the less likely that objective and subjective factors will destroy the project in the future.

The issues that arise in the context of investment projects can be conditionally divided into two large groups:

  • issues related to asset and business due diligence;
  • issues of structuring relations between partners.

Due diligence

Prior to purchasing assets or a company, or deciding to participate in a project together with other partners, we strongly recommend conducting due diligence of the relevant investment project. It is subject to both legal issues and other important aspects.

For example, the structuring of energy projects shall take into account the possibility, procedure and cost for grid connection; the guaranteed price level for electricity purchase and the risks of its review; conditions for concluding construction works contracts; conditions for subsequent operation of power plants.

Some objectives of due diligence are: identification of so-called deal breakers (risks that call into question the expediency of project participation), reduction of the acquisition price / investment amount as well as providing grounds for claiming appropriate contractual guarantees, covenants and options from the seller and / or introducing other additional mechanisms to protect the investor’s rights.

Experience has shown that a common mistake, in addition to refusing to conduct due diligence in general, is to conduct shallow due diligence when the emphasis is put on general issues (for example, the corporate matters), rather than on special issues and risks inherent in the relevant industry.

For example, in analyzing the possibility of grid-connection, it is important to assess the possibility the possibility of obtaining easements for the construction of power lines on adjacent land plots rather than mere existence of a contract with the grid operator defining grid-connection fee.

Special attention should be paid to permitting documents (licenses, certificates, permits, etc.) and shall not be limited to formal existence and validity check. Generally, errors and violations in the process of obtaining documents can lead to revocation of licenses and loss of the project in the future.

In addition, as part of the project review, it is worth paying attention not only to documents, but also to current judicial practice. In some cases, conflicts of law and changes in the position of the courts towards them can cause problems even in cases where they are not initially obvious when analyzing documents.

When the corresponding risks materialize in subsequent stages, it is often no longer possible to cover them at the expense of sellers / local partners.

Structuring relationships with partners

The issues of building a balanced corporate governance and control structure are especially relevant if a foreign investor enters the project together with local partners. Often, in such situations, the investor undertakes primarily to finance the project, while the local partners are responsible for its implementation and further operational management.

It should be noted that in terms of strategy, this model seems to be absolutely justified – often a foreign investor has the opportunity to attract low-cost financing, while local partners have more knowledge and experience in relation to local specifics. However, often the real situation differs from the ideal one. Sometimes there are examples of banal bad faith of local partners (for example, overstatement of budgets for work when attracting their contractors), but more often local partners can apply methods and practices that are not in a line with international standards, and not always implement the project in accordance with the reasonable expectations of a foreign investor.

If the strategy for the implementation and management of the project, as well as the mechanisms for monitoring current activities, were not formalized in advance at the initial stages, then forcing local partners to fulfill the relevant requirements, and, if necessary, changing management to representatives of the investor can be problematic. This also applies to cases where the investor owns a majority stake in the project.

In order to avoid such situations, it is recommended to agree upon the detailed rights and obligations of each party as well as to formalize them at the initial stages. Moreover, Ukrainian legislation now allows (albeit not quite ideally) to regulate the relationship between partners under a corporate agreement concluded in Ukraine, which can also be applied for small projects where the costs of establishing and maintaining a foreign holding company and concluding a shareholder agreement under foreign law do not seem appropriate.

Operational monitoring is also very important; the existence of the corporate agreement / shareholder agreement itself is not a guarantee against unfair management decisions. While the dispute is being considered in court or arbitration, irreversible damage may be caused to the project. The best mechanism for such monitoring is the creation of a management board, the appointment of an investor representative to the management board and assignment of the obligation to sign all documents above the established materiality threshold by two directors as well as the approval of the relevant bank payments by the second director. There are also many practical nuances in this model, including, for example, the correct assignment of the monitoring function in the charter and the technical ability to approve payments by the second director in the client-bank system. At the same time, this model, if properly implemented, seems to be the most effective in terms of operational monitoring.

If a problematic situation has already arisen, it is important, first of all, to develop the appropriate exit strategy and correctly assess its legal position. Further, it is advisable to avoid extremes. On the one hand, it is undesirable to be too soft in negotiations, since this is often regarded as weakness in Ukraine. On the other hand, it is important not to do too drastic rash actions that can damage the project as a whole; there is no point in winning if the project is already becoming unimplemented or economically unprofitable during the conflict.

Another option to avoid conflicts in project management is the use of contractual instruments instead of corporate ones. For example, in some cases, development services agreements services could serve as a good alternative to the payments under share-purchase agreement allowing investor for more flexible and result-oriented arrangements with the developer.

In such agreements, the developer’s remuneration depends on the achievement of specific purposes and performance indicators of the project: connection to the grid, obtaining licenses, reserving a certain tariff rate, starting commercial operation of the power plant, etc.

In turn, the absence of corporate rights of minority project participants can save the investor from the conflict situations described above.

Sergiy Benedysiuk, partner, head of corporate and M&A, and Ivan Bondarchuk, counsel, head of energy and natural resources, exclusively for Yurydychna Praktyka