Nearly all of the $190-million the Ontario government paid in compensation to scrap a controversial power plant west of Toronto went to eight hedge funds based in the United States and Cayman Islands to cover a controversial loan.

The hedge funds pocketed $149-million, more than twice as much as they had put up for the project, after a prolonged and aggressive legal battle in the courts in New York and Ontario. The hedge funds, all connected to Washington-based EIG Management Co., gained the upper hand thanks to an unorthodox financing agreement they had with the project developer, according to thousands of pages of internal government correspondence and legal filings reviewed by The Globe and Mail. And they took full advantage.

The province's problems began shortly after the Liberals decided to scrap the Mississauga power plant during the dying days of the 2011 election campaign.

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That decision triggered a default on the loan and some costly penalties. The loan only dated back to May, 2011, when the hedge funds agreed to provide $260-million in construction financing to Eastern Power Ltd., the company building the power plant.

Eastern had borrowed just $61-million as of November, 2011, documents showed. But once the project was cancelled, the hedge funds sued the Ontario government the following March for $300-million in damages. Those damages included a so-called "yield maintenance amount" – which essentially treated the undrawn portion of the financing as if it had already been dispersed.

That provision shocked Rocco Sebastiano, a lawyer at Osler Hoskin & Harcourt LLP retained by the Ontario Power Authority, a provincial agency in charge of the negotiations. "I fell off my chair when I saw the yield maintenance amount being claimed by EIG," Mr. Sebastiano said in an e-mail dated Nov. 24 to officials at the Power Authority. "This sounds like a usury charge to me frankly."

The interest the hedge funds were claiming on the loan would have exceeded the 60-per-cent threshold allowed under the Canadian Criminal Code, Mr. Sebastiano said.

In November, 2011, the Power Authority offered the hedge funds a yield maintenance amount of $35-million, which was just under the 60-per-cent threshold. The hedge funds rejected the offer and headed to court. Their Toronto lawyer, Peter Howard of Stikeman Elliott, told the OPA there was no "risk premium" built into the amount, documents show.

The government finally agreed last July to strike a much more generous settlement: The hedge funds received the $61-million they advanced on the financing, plus $88-million in yield maintenance payments.

There is nothing in the documents that explains the government's largesse to the hedge funds. The paper trail of government correspondence ends abruptly, more than six months before the settlement was reached last July. An order from the Speaker of the legislature required the government to disclose only those documents dated between September, 2010 and Dec. 31, 2011, in connection with cancelling two power plants in Mississauga and Oakville.

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"We wanted to pay EIG as little as possible," Nauman Khan, a spokesman for Energy Minister Chris Bentley, said in an e-mail response to The Globe. "In the end, we're confident we did just that when we negotiated a settlement of $149-million, which was less than half of what EIG was seeking."

Officials at EIG did not return telephone messages and e-mails seeking comment. Lawyers representing EIG in Toronto and New York also did not respond to several phone calls and e-mails.

The power authority also paid $31-million to cover suppliers and Eastern's overhead costs. As well, Eastern received $10-million to settle an unrelated lawsuit dating back to 1998 that the company had with the former Ontario Hydro. Together with the payment to the hedge funds, the total cancellation costs hit $190-million.

The controversy over the cancelled power plant serves as a cautionary tale for governments as they increasingly shift services from bureaucrats to the private sector. The risks associated with these projects are supposed to be borne by the private sector. But when deals unravel, it is taxpayers who are left on the hook.

Premier Dalton McGuinty 's government has inked dozens of major infrastructure deals with the private sector to build hospitals, courthouses and electricity plants during its nine years in office. The government's push to replace pollution-spewing coal-fired plants with cleaner sources of energy has ended the Crown's monopoly on generating electricity in Ontario.

The origins of the Mississauga project date to 2005, when the government awarded Eastern a contract to build a 280-megawatt, gas-fired power plant known as Greenfield South. The project was delayed for years and Eastern had difficulty raising money for construction because many lenders were leery about its ability to complete the $350-million facility, documents show. That meant the company had to turn to the hedge funds.

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The hedge funds agreed to provide financing, but they put the company on a short leash. Eastern could only withdraw money monthly and only for approved construction expenditures. In return, Eastern had to pay 14-per-cent interest on borrowed funds and pledge control of the company and virtually all of its assets as collateral.

Once the dispute over the cancellation wound up in court, the hedge funds pushed hard and won enough rulings that at one point they were ready to hold an auction to sell off Greenfield and its assets, moves that would have jeopardized the government's plans to relocate the power plant. The settlement ended the legal proceedings, but the fallout from the aborted project is far from over.

Jim McCarter, the province's Auditor-General, told The Globe his office is probing the costs associated with cancelling the Mississauga power plant. Energy consultant Tom Adams is also attracting dozens of visitors to his website, where he has posted all the gas plant documents.

Committee hearings into the gas plants are on hold indefinitely, however, now that all business at the legislature has ground to a halt. Mr. McGuinty asked the lieutenant-governor to prorogue the legislature last month, the same day he announced he was retiring after nine years in office.

"He pulled the plug because he wanted to make sure those hearings didn't happen," said Peter Tabuns, energy critic for the New Democratic Party.