Law and Project Finance

Abstract:     
We investigate Project Finance as a private response to inefficiencies created by weak legal protection of outside investors. In the context of large investment projects, we offer a new illustration that law matters by demonstrating that Project Finance offers a contractual and organizational substitute for investor protection laws. Project Finance accomplishes this by making cash flows verifiable, thereby enhancing debt capacity. Project Finance makes cash flows verifiable through: (i) contractual arrangements made possible by structuring the Project Company as a single, discrete project legally separate from the sponsor; and (ii) private enforcement of these contracts through a network of project accounts that ensures lender control of project cash flows.

Comparing the incidence of bank loans for Project Finance with regular corporate loans for large investments ("Corporate Debt Finance"), we show that Project Finance is more likely in countries with weaker laws against insider stealing and weaker creditor rights in bankruptcy. In addition, stronger creditor rights mitigate the marginal effect of weaker laws against insider stealing on the choice of Project Finance versus Corporate Debt Finance. We employ cross-country tests as well as time-series, difference-in-difference tests that exploit country-level changes in legal rules.

Keywords: Agency Cost, Bankruptcy Cost, Corporate Finance, Free Cashflow, Investor Protection, Leverage, Limited Recourse, Project Finance, Self-Dealing

JEL Classifications: G32, G33, G34, K22

Working Paper Series