Law, Agency Costs and Project Finance

We investigate Project Finance as a private response to ine¢ ciencies created by weak legal protection of outside investors. In the context of large investment projects, Project Finance o¤ers a contractual and organizational substitute for investor protection laws by making cash ‡ows veri…able, thereby enhancing debt capacity. Project Finance makes cash ‡ows veri…able 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 ‡ows. 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 laws. In addition, stronger creditor rights mitigate the marginal e¤ect of weaker laws against insider stealing on the choice of Project Finance versus Corporate Debt Finance. To provide this evidence, we employ cross-country tests as well as time-series, di¤erence-in-di¤erence tests that exploit country-level changes in legal rules. JEL classi…cation: G32, G33, G34, K22