Updated: Feb 12
In project finance, when several banks are bound by an intercreditor agreement, it often happens that the hedging instruments are not allocated among the various lending banks in proportion to their loan outstandings, or that the hedging instruments are not concluded at the same fixed rate level by all hedging banks.
In such situations, the question often arises as to whether this introduces a breach of the pari passu principle.
The Pari Passu Principle in Project Finance
1. The Pari Passu principle
In project finance, mechanisms pre-agreed by the parties through the intercreditor agreement (ICA) organize the liquidation in case of project default. These mechanisms generally include the following principles:
A single security agent manages the project security; no creditor may enforce the security on its own.
Different classes of creditors are defined.
The waterfall is predefined and sets out the order in which creditors within each class will be paid.
Within the same class, creditors are treated pari passu, meaning they have the same priority over the security package, the same priority in the waterfall, and benefit from the same recovery rate. They therefore benefit from equal treatment in proportion to their claims.
It is generally provided that the claims of the hedging banks belong to the same class as the claims of the senior lenders.
2. The Liquidation Mechanism for Lenders and Hedging Banks
For the class composed of senior lenders and hedging banks, recovery calculations are made through three stages.
a. Determination of Available Assets
The security agent determines the amount that may be distributed to these creditors.This amount includes the termination value of hedging instruments whose Mark-to-Market (MtM) is positive for the project.
This MtM is crystallized during liquidation by the hedging bank, which triggers the Automatic Termination Event (ATE) linked to the default, calculates the termination amount, cancels the swap, and pays the corresponding amount to the security agent.
b. Determination of Claims
The claims of senior lenders consist of outstanding principal plus accrued but unpaid interest.
The claims of hedging banks consist of the termination amount of hedging instruments with a positive Mark-to-Market (MtM) for the Hedging banks.
This MtM is crystallized through the same ATE process as described above.
c. Calculation of the Recovery Rate
For this creditor class, the security agent determines the ratio between available assets and total claims and calculates a single recovery rate.
This rate applies uniformly to all creditors in the class - senior lenders and hedging banks - who are therefore treated equally.
In a standard project financing - except in specific cases - loan claims and hedging claims rank equally and are treated identically. If the senior lenders’ recovery rate is 70% (i.e., the available assets represent only 70% of the senior liabilities), each senior creditor receives 70% of its claim, meaning a 30% loss. Thus, a lender with a €50 million loan receives €35 million, and a hedging bank with a €10 million claim receives €7 million.
d. Conclusion
The hedging bank is therefore subject to an asymmetry: when the termination amount is in its favor, its claim increases, whereas when the termination amount is in favor of the project, its claim is not reduced, as project finance structures do not allow set-off between the loan and the hedging instrument.
However, the hedging bank does not suffer a loss when it pays the MtM of the hedging instrument to the security agent, as it simultaneously cancels the hedging instrument from its balance sheet, thereby eliminating its negative value, which offsets the cash paid (to the security agent).
Furthermore, the hedging bank receives a specific margin to compensate, ex ante, for its costs and risks.
The Pari Passu Principle for Lenders and Hedging Banks
1. Pari Passu as a Principle of Proportional Equality
Pari passu liquidation between senior lenders and hedging banks implies, beyond an equal ranking in the waterfall, a principle of equality of recovery rates, not equality of claim amounts.
There is obviously no equality of claim amounts when banks have different loan exposures - a frequent occurrence - yet this does not constitute a breach of pari passu.
There is also no equality in the amount of claims when banks have the same loan portfolios and the same hedging instruments, but the calculated termination balances (associated with their hedging instruments) differ, for example, because those balances were not determined on the same date. However, this valuation difference does not call into question the pari passu principle.
2. Pari Passu applied to variable claims
When hedging instruments are in place, the amount of claims that would be presented to the security agent in the event of enforcement is uncertain, as it depends on the mark‑to‑market value of the hedging instruments at the time of termination. As a result, the recovery rate of senior lenders on their loans depends not only on the recoverable value of the project assets, but also on the value of the hedging instruments.
When the Mark‑to‑Market of the hedging instruments is negative for the project - typically because rates have fallen since hedging - this negatively affects the recovery rate of senior lenders. Hence, it is important that senior lenders be informed of the hedging instruments put in place before or after financial close, as they influence the project’s overall risk profile.
By contrast, the fact that these hedging instruments are carried, post‑closing, by one hedging bank rather than another has no impact on the recovery rate of senior lenders.
3. The Impossibility of offsetting Hedge Value against loan claims benefits all senior creditors
A hedging bank cannot offset a negative MtM on its hedges against its loan claim. When the MtM is negative, the hedging bank’s negative exposure is treated like a loan claim.
Conversely, when the MtM is positive, the sums paid by the hedging banks increase available project assets, benefiting all senior creditors.
Examples of particular situations
1. Two Banks share the loan equally, but only one provides hedging
This is a standard situation where one of the lenders is not able to provide hedging instruments.
Does this misalignment undermine the pari passu principle?
If, at the time of default, the MtM is positive for the project:
The hedging bank pays this amount to the security agent. This improves the senior creditors’ recovery rate.
Both banks receive the same recovery rate and the same amount on their loan claims.
Their losses are equal and proportional to their loan exposure.
If, at the time of default, the MtM is positive for the bank:
Bank A presents its loan claim and its hedging claim.
Bank B presents only its loan claim.
Bank A’ s total claim is higher.
However, each bank ultimately bears a loss proportional to its total claim.
In practice, this is equivalent to Bank A having a larger economic interest in the project than Bank B. Nevertheless, all creditors continue to be treated on an equal footing. Further, Bank A has been compensated through the swap margin for the additional exposure it agreed to assume.
2. Both Lending Banks provide hedging proportionally, but at different Fixed Rates
This is a standard situation when one of the two banks acted as the sole pre‑hedging bank, or when the pre‑hedge was transferred to only one of the two banks.
Does this difference in Fixed-Rates undermine the pari passu principle?
One of the two banks has a larger potential claim arising from the hedging instruments than the other. The value difference between these two potential claims is relatively stable and amortises over time, as it corresponds to the present value of the interest rate differential. In consideration for this potentially larger claim, the relevant hedging bank received a higher margin.
The generic pari passu principles remain fully applicable: Lenders and Hedging banks have proportional access to security relative to their claims and recovery rates remains identical. It should be noted that the recovery rate for this class of claims does not differ from a scenario in which the additional claim arising from the pre‑hedging arrangement had been allocated between the two lending banks. However, it is clear that recovery rates are affected by the value of the hedging instruments. It is therefore essential that lenders are fully informed of any pre‑hedging arrangements prior to submission to the credit committee and remain continuously informed, on an ongoing basis, of the characteristics of the hedging instruments held by the project.
This occurs when one bank provided the pre-hedge alone, or the pre-hedge was transferred to only one bank.
3. The Case of Orphan Hedging Banks
Let us now consider the case where the misalignment arises from the presence of a hedging bank that is not a lending bank [1]. Such a bank is commonly referred to as an “orphan hedge bank.”
In this situation, a hedging bank that has entered into hedging instruments with a positive Mark‑to‑Market value for the project may, in the event of a project default, incur no loss at all, as it is exposed neither under the hedging instrument nor under the loan. In certain circumstances, such a hedging bank could therefore have an incentive to trigger a project default, allowing it to eliminate any future potential exposure while immediately crystallising the full margin.
While this situation does not constitute, stricto sensu, a breach of the pari passu principle, it does give rise to a potential conflict of interest. As a result, when an orphan hedge bank is involved, the lending banks typically ensure that the finance documentation restricts the rights of such bank, in particular its rights to trigger an event of default - an arrangement that experienced project finance counsel are well accustomed to structuring.
Conclusion
Deviating from a strict pro rata allocation between loan exposures and hedging instruments, or accepting differences in fixed rates between hedging banks, does not undermine the principle of equal treatment of creditors in a project finance transaction.
Such misalignments result ex ante in a higher risk exposure for the hedging bank that holds a larger notional amount of hedging instruments or benefits from a higher fixed rate under its hedge. The lending bank that does not hold any hedging instruments is indirectly impacted by the swap claim, as this claim reduces its recovery rate on the loan; however, its recovery rate is no different from a scenario in which the same hedging instruments had been allocated evenly among the lending banks.
In any event, all banks party to an intercreditor agreement should be given the opportunity to participate in the hedging instruments and should therefore be consulted by the sponsor. They should also be informed as early as possible of any hedging instruments put in place, as these instruments affect the overall risk profile of the project in which they participate.
[1] Or where the loan exposure is significantly smaller than the hedging exposure
