Corporate Governance

Shearman & Sterling LLP 34 | The Rise of the Green Loan Market SELECTION, MEASUREMENT, VALIDATION AND CONTRACTUAL PROVISIONS In the absence of governmental regulation or significant guidance, lenders and borrowers, both individually and as members of industry groups, have settled on some broad approaches to loan selection, measurement and validation, and how these are handled in loan agreements Green Loans For green loans, a lender typically requires that a borrower submit a satisfactory action plan that sets out precisely how the loan proceeds will be spent. A lender's internal sustainability auditors or its outside consultants, commonly referred to as second-party opinion providers, will analyze the proposed green project, as well as the borrower's capacity to ensure that the loan proceeds are spent on the project and its ability to effectively manage any risks posed by the project. This review results in the lender or second- party opinion provider issuing an evaluation report. Should the lender choose to proceed with the loan, the loan agreement will require the borrower to monitor the progress of the green project and meet and maintain any specific milestones — e.g., in the context of green buildings, achieving the US Green Building Council's Leadership in Energy and Environmental Design, or LEED, certification. The agreement will also require the borrower to report on the progress of the green project on its website and/ or in reports submitted to the lender. Some industry guidance documents call for annual reporting, although a lender may require more frequent reporting. A lender may also require a borrower's reports to be verified or certified periodically by independent third parties and for the borrower to provide access to personnel, documents and perhaps projects for this purpose. Depending on a lender's familiarity with a borrower and confidence in its internal oversight processes, a borrower's self-certification procedure could suffice. The loan documentation may require funds to be segregated in a dedicated account, a concept familiar to project finance borrowers. This may not be required if the borrower operates exclusively in green industries or if the lender is satisfied that a borrower has effective internal fund allocation controls and procedures. The documentation is likely to include some negative consequences for the borrower in the event it fails to meet its green obligations — for example, by spending the funds on a project other than the agreed project or failing to obtain a relevant certification. The documentation may require a borrower to segregate funds in a dedicated account to remedy the relevant breach. A mandatory prepayment is a more aggressive remedy. If such a remedy were agreed to in principle, the borrower might consider whether a cure period is appropriate. Penalty clauses, however, are not a favored provision as they could have the perverse result of the lender reaping benefits from the borrower's green failures. ESG Loans For ESG loans, the first step is for the lender and borrower to agree on the PSTs — what metrics are relevant and how they will be judged. The most central loan provision is a reduction in margin if the borrower meets the PSTs. If a borrower fails to meet the PSTs, and to eliminate the outcome of a lender enjoying a higher margin based on a borrower's ESG failures, a payment could be required to an account with funds only being available to improve the borrower's sustainability profile, sometimes requiring the lender's prior consent for incurrence. Similar to green loans, ESG loans typically require meeting milestones, regular reporting and third-party verification or certification of results. Predetermined Sustainability Targets Predetermined Sustainability Targets (PSTs) are established metrics to further sustainability goals and can relate to, among other things, an increase in energy efficiency, the promotion of biodiversity or improvements in working or social conditions. Unlike with a green loan, proceeds from an ESG loan do not need to be allocated to a green project. In most cases, proceeds from ESG loans are allowed to be used for general corporate purposes. With an ESG loan, the loan terms for the borrower, such as through margin determinations over the life of the loan, may become more favorable if the borrower meets its PSTs or less favorable if it does not meet them. Green loans and, when the "E" in ESG is the focus of the loan, ESG loans are also often referred to as sustainable loans or sustainability-linked loans.

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