This article considers the legal implications of new rules of the recently revised Equator Principles (EP), whose third iteration (“EP III”) took effect on May 14th, 2013. The Equator Principles is a framework agreed upon by 79 global financial institutions to identify, assess and manage environmental and social risk in certain types of financings around the world. The goal is to provide an overview of the EP III with discussion of steps that counsel to EP Financial Institutions (EPFI) might consider to minimize potential legal risks and update contractual documentation.I. Understanding the Key Requirements of EP III
a.) Expanded Scope
As before, the EP III applies globally to all industry sectors, subject to a monetary threshold and limited to certain types of financings. Earlier versions of the EP only applied to project financings over $10 million. The strategic review leading to EP III reviewed the definition of “project finance” in light of concerns that project financings with challenging environmental and social risks were being disguised as corporate loans to avoid application of Equator Principles.
The recommendation of the strategic review was to widen the scope of the Equator Principles to apply to corporate loans where 50 percent or more of the proceeds of that loan are being used to finance a single asset as well as certain bridge loans and project finance advisory services. As in previous iterations, EP III requires EPFIs not to provide such loans or financing where the borrower will not or is unable to comply with the social and environmental requirements of the EP.
b.) Emphasis on Legal Compliance in First Instance
EP III emphasises the primacy of legal and regulatory compliance in addition to compliance with the best practices set by the International Finance Corporation of the World Bank (namely the IFC Performance Standards and Environmental Health and Safety Guidelines). EPFI are responsible for overseeing and auditing client compliance with EP III, which includes compliance with laws and regulations. Principle 3 now states that the Environmental and Social Impact Assessment (“Assessment”) process should “in the first instance”, address compliance with relevant host country laws, regulations and permits that pertain to environmental and social issues. This makes the Assessment process primarily a legal compliance assessment, in the first instance.
Oddly, most EPFI do not retain legal advisors to conduct legal diligence, instead relying on engineers or social scientists. The specific legal compliance focus of EP III presents an opportunity for EPFIs to streamline their EP Assessment and diligence processes by integrating it with legal and regulatory compliance reviews for the same projects, by utilizing environmental and social specialist legal counsel to support internal reviews along with corporate counsel that structure the same deals.
c.) Review and Categorization
EP III continues to require EPFI to conduct a preliminary assessment of the level of environmental and social risks associated with a project and to categorize that risk as either Category A (significant risks), B (limited risks) or C (minimal or no risks). Categorization of projects is a highly discretionary and inexact process. The EP III categorization process is not intended to be a “once and for all” exercise and will typically be reviewed at least annually or whenever changes to the project occur that could affect the level of environmental and social risk of a project.
d.) Environmental and Social Impact Assessment
Assessment involves a benchmarking exercise to evaluate the applicable standards (including laws, regulations and the IFC Performance Standards) and to evaluate the risks of non-compliance, collect baseline data and identify associated reputational risks. An Assessment must be developed for all Category A and B projects, providing an evaluation of the environmental and social risks of the project. While legal and regulatory compliance is essential for all projects, in "limited high risk circumstances" the Assessment should also include specific human rights due diligence based on the Guiding Principles on Business and Human Rights (Guiding Principles).
The Assessment is usually commenced prior to the development of contractual documentation but may not be completed before financial close. This may necessitate specific covenants, undertakings and representations providing for the completion of the Assessment process and adherence by the Borrower to its findings.
e.) Application of Environmental and Social Standards and Regulations
Beyond compliance with relevant host-country laws, regulations and permitting requirements, EP III requires that projects in "Non-Designated Countries" comply with the “then applicable” IFC Performance Standards and the EHS Guidelines. “Designated Countries” include 31 high GDP countries with robust legal environmental and social protections whereas “Non-Designated Countries” include the rest of the world.
Where applicable, there are eight IFC Performance Standards to be applied on the following topics: (1) Assessment and Management of Environmental and Social Risks and Impacts; (2) Labour and Working Conditions; (3) Resource Efficiency and Pollution Prevention; (4) Community Health, Safety, and Security; (5) Land Acquisition and Involuntary Resettlement; (6) Biodiversity Conservation and Sustainable Management of Living Natural Resources; (7) Indigenous Peoples; (8) Cultural Heritage. These standards are applied to “fill the gaps” of applicable laws and regulations on the same topics.
f.) Environmental and Social Management System, Management Plan and Action Plan
EP III requires the development by the borrower of an Environmental and Social Management System (ESMS), which is composed of policies, procedures, organizational, training and stakeholder engagement requirements. In addition, the borrower must develop an Environmental and Social Management Plan (ESMP) to address issues raised in the Assessment and incorporating actions to comply with the applicable standards.
Where the ESMP is not adequate, an additional document called an Action Plan (AP) will be developed to address gaps “to the EPFI’s satisfaction”, in line with applicable standards. Contractual documentation must set out the necessary representations, information covenants, project covenants and conditions precedent to ensure that the ESMS is developed by the borrower and the requirements of the AP fulfilled to the EPFI’s satisfaction.
To this end, thought must be given to what documents will be needed and how and when reporting between the borrower and EPFI will take place.
g.) Stakeholder Engagement
For all Category A and Category B projects, the borrower must demonstrate effective and ongoing “stakeholder engagement” with affected communities and other stakeholders, taking into account disadvantaged and vulnerable groups. EPFI clients must take account of and document the results of the Stakeholder Engagement process, including agreed actions.
h.) Grievance Mechanisms
For all Category A and B projects the borrower must create a “grievance mechanism” as part of the ESMS, designed to receive and facilitate resolution of concerns about the project’s environmental and social performance. Grievance mechanisms for workers are also required by the IFC Performance Standards.
i.) Independent Review
For Category A and, “as appropriate”, Category B projects an “Independent Environmental and Social Consultant” not directly associated with the borrower will carry out an independent review of the Assessment, ESMP, ESMS and consultation process findings. The purpose of independent review is to assist the EPFI’s due diligence efforts, assess overall EP and legal compliance and to propose a suitable AP capable of bringing the project into compliance or to indicate when compliance is not possible.
For Project-Related Corporate Loans, an independent review is required for projects with high-risk impacts. As noted, despite the emphasis on legal due diligence, there is typically little or no involvement of legal counsel in such independent reviews. In light of the multiple legal risks associated with such financings, including risks beyond the EP itself such as anti-corruption, the benefits of utilizing specialist legal counsel to conduct EP independent reviews is evident.
j.) Covenants
EP III requires EPFIs to include at least four covenants in financing documents regarding EP implementation.
- a) to comply with the Management Plans and Action Plans during the construction and operation of the Project in all material respects; and
- b) to provide periodic reports in a format agreed with the EPFI (with the frequency of these reports proportionate to the severity of impacts, or as required by law, but not less than annually), prepared by in-house staff or third party experts, that i) document compliance with the Management Plans and Action Plan (where applicable), and ii) provide representation of compliance with relevant local, state and host country environmental and social laws, regulations and permits; and
- c) to decommission the facilities, where applicable and appropriate, in accordance with an agreed decommissioning plan.
Ultimately, if the borrower is not in compliance with these covenants the EPFI should work with the borrower on remedial actions to achieve compliance.
Where non-compliance persists beyond a grace period, the EPFI may exercise remedial rights set out in contractual documentation. EPFIs commit to not providing financing to clients that cannot or will not comply with the EP.
To ensure that this can be achieved, financing documentation must take proper account of the requirements of the EP in drafting representations, information covenants, project covenants and conditions precedent to ensure borrower obligations are properly set out.
k.) Independent Monitoring and Review and Reporting and Transparency
For all Category A and, as appropriate, Category B projects an independent advisor must still be appointed by the EPFI or borrower to ensure ongoing monitoring of compliance and reporting to the EPFI over the life of the loan, following Financial Close (a defined term meaning the date on which all conditions precedent to initial drawing of the debt have been satisfied or waived).
The same process is applied for Project-Related Corporate Loans wherever an independent review is required. EP III also sets out specific requirements for public reporting of environmental and social data, including a summary of the Assessment and specific reporting requirements in relation to greenhouse gas emissions noted above. EP III also sets out requirements for annual EPFI reporting of EPIII activity.
To ensure adequate monitoring and reporting on EP compliance, obligations of the borrower must be set out in contractual documentation at the outset. As well, to minimize legal liability risks for both the lender and the borrower that may arise from ongoing monitoring and reporting on potential instances of non-compliance, legal professional privilege should be sought and maintained for all audits and monitoring reviews, by retaining legal counsel to oversee such processes. This must be balanced with the imperative for transparency that is central to the goals of the EP.
II. Litigation Risks and Legal Strategies
There is clearly a business case for banks to follow EP III, particularly to address the reputational, legal and financial risks associated with their clients’ environmental and social performance. However, by holding themselves out as overseers of their clients' environmental and social performance and publicly reporting on environmental and social compliance, EPFIs are exposed to legal risks beyond the inherent risks of the project financing.
a.) Lender Liability Risks
Lender liability for environmental and social matters may arise from operational or managerial control by a lender over a project. In many regulatory regimes, owners of projects can be held liable for offences associated with the owned operations. That being so, most EPFIs have little experience being the subject of regulatory investigations as lenders in the context of environmental, health and safety, or labour standards for their financed projects. In implementing EP III EPFIs may increasingly find themselves exposed to their borrowers’ environmental and social regulatory risks, particularly where their oversight leads them to participate in the management of their clients’ environmental and social risks.
By adopting the role of overseer with respect to environmental and social impacts, EPFIs may be taking on an active role and responsibility under national regulatory schemes. Wherever EPFIs are auditing and assessing legal and regulatory compliance of their borrowers and even suggesting management approaches through the Action Plan and monitoring and review processes as "partners" with their borrowers, there will exist the possibility that an EPFI could be accused of a regulatory offence, along with their borrowers. That means that both the EPFI as corporations, as well as individual employees, officers or directors of EPFI, could find themselves the subject of a regulatory prosecution in relation to an EP project, by virtue of their EP commitments as either a co-manager or party to a regulatory offence of their borrower clients.
Maintaining legal professional privilege over EP related compliance assessments is critical for EPFI to manage such risks, but cannot be preserved unless legal counsel are retained to produce such reports.
b.) Fraudulent Activities or Misrepresentations
Even in the absence of specific regulatory requirements, there is a risk that failure to adhere to public commitments to conduct EP related due diligence and ensure compliance of financial clients could give rise to a fraudulent activities or misrepresentation.
An interesting analogy to EP legal risks arises from the recent London Interbank Offered Rate (LIBOR) investigations and fines. LIBOR is the interest rate at which banks offer to lend to one another on the international inter-bank market. In June 2012 it became apparent that a number of banks had been manipulating LIBOR for their benefit to either make their positions look more secure, or to make a greater profit. Legal action was pursued against the banks by regulators, with fines levied in the hundreds of millions of dollars.
Like LIBOR, implementation of the EP process is not formally administered by governments. However, as was the case with LIBOR, EPFI create reasonable expectations in the market that their EP commitments will be implemented without negligent or deliberate misapplication. Should such commitments be deliberately or negligently breached by EPFI, there would be avenues through fraud laws or shareholder claims for potential legal consequences emerging from the detrimental reliance of market actors, shareholders or public regulators on the commitments of EPFI.
c.) Third-Party Beneficiary Rights
Another potential legal risk arising from EP III is liability to potential third-party beneficiaries such as employees, unions, local communities or other stakeholders. Privity of contract would generally preclude non-parties to the financing agreement to seek redress for EP III commitments. But, viewed in the context of third-party beneficiary rules in common law jurisdictions, privity may not protect EPFIs from suits by individuals in communities affected by a project under EP III. The potential third-party claim could flow from the Adoption Agreement signed by the EPFI when joining the Equator Principles, which includes a commitment by the EPFI to “put in place internal policies and procedures for environmental and social risk management consistent with [EP III].” This text explicitly identifies “local stakeholders”, and implicitly identifies those whose human rights might be affected by a project as third-party beneficiaries of EP III due diligence obligations.
Beyond the preamble, many of EP III’s substantive requirements, including compliance with the IFC Performance Standards and EHS Guidelines, are drafted with the clear purpose of protecting the rights of stakeholders affected by a project’s environmental and social impacts. Similar commitments, including specific covenants to apply standards that would benefit affected communities, employees and other local stakeholders, are made directly in Facility Agreements between EPFI and their clients where the EP III applies.
Such commitments, in the absence of clear exclusions of third party beneficiary rights, could give rise to potential rights and associated claims.
III. Recommendations for Addressing EP Related Litigation Risks
Legal implications are important for EPFI counsel to understand and plan for in reviewing the new EP III. To this end, some final strategic considerations in dealing with these issues include:
- Utilize legal counsel in conducting Assessments and Independent Reviews to ensure that legal diligence is done correctly with professional liability coverage and with the application of legal professional privilege;
- Consider how past agreements can be revised (taking into account restrictions on removing or rescinding third party beneficiary rights) to address legacy liabilities or the risk that third parties may have rights to enforce EP commitments under contractual terms;
- Revise third-party beneficiary language in EP-related contracts to ensure that third-party beneficiary rights are expressly excluded, to reduce the possibility that there is an inference of such rights should a claim be made (although this will not protect against claims raised under the Adoption Agreement);
- 4. Use indemnities to shift monetary consequences of third party claims from EPFI onto borrowers, who are ultimately intended to be responsible for managing environmental and social issues;
- Ensure internal legal oversight of due diligence processes, public reporting, stakeholder engagement and consultation activities, to ensure litigation risks are effectively managed;
- Preserving and applying (where appropriate) legal privilege, balanced against the interest of transparency that is integral to the EP’s purpose, to prevent internal compliance assessments from forming the basis of future regulatory prosecutions or lawsuits.
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