What is the practical value of step-in rights in collateral warranties? I ask because a number of people have recently questioned me about such rights in the context of a development project: who requires them and in which warranties?
Who wants step-in rights?
Obviously, a funder providing finance for a project will insist on step-in rights. So might a purchaser, in certain circumstances. Some beneficiaries of collateral warranties from a building contractor (which contain step-in rights) insist that step-in rights are also included in collateral warranties from sub-contractors, even though step-in rights in sub-contractor warranties have traditionally not been regarded as essential.
The recession has increased demand for step-in rights
Given the recent dramatic increase in insolvency across the industry, the need for parties, in particular funders, to protect their interests in these circumstances has become much more important. Step-in rights, including those in relation to key sub-contracts, are regarded as one way of protecting against insolvency. However, being able to tick the “step-in rights box” doesn’t tell us much about what happens in practice in a construction insolvency situation.
Funders rarely step-in
In my experience, funders will hardly ever opt to activate the step-in rights in collateral warranties in their favour. This is unsurprising. If a bank (or its nominee) steps into a contract, it will have to take on liability for outstanding breaches of the underlying contract as a condition of stepping in. For example, the bank may have to pay a considerable amount of money to a contractor before it is able to step into the building contract. This makes exercising step-in rights unattractive and very much a last resort. Other alternatives are always explored.
Alternatives to stepping-in
There is a bit of a paradox here. While including step-in rights has become more important during the recession, the scope for choosing alternative solutions has increased. A recent example of this springs to mind. We are advising the funders in relation to a development project where the developer has become insolvent. Stepping into the relevant contracts was not considered to be a practical solution. Instead, the administrators (appointed by the bank) agreed with the consultants and package contractors that they would continue to work on the project to completion in return for what was, effectively, payment of a proportion of outstanding sums and payment of a lump sum “completion” fee. As regards the balance of monies owed, the team would have to take their place as unsecured creditors of the developer.
The contractor and consultant’s perspective
A consultant or contractor would have to be fairly bold to refuse such an offer and attempt to force the bank to step in by serving a termination notice under the underlying contract. The risk is that a bank may choose not to step in, leaving the other party with no entitlement to payment other than to such sums as it is able to recover as an unsecured creditor. The value of a “bird in the hand” is an important consideration in these circumstances.
A significant factor in the project that I was involved in was that it was fairly close to practical completion. If the project was much less advanced, the contractor and consultants might have had more leverage to negotiate better terms. Regardless, the striking thing is that, in a situation which seemed to be a prime candidate for a funder step-in, step-in rights were not used. I doubt that this is the only project that has been dealt with in this way in recent months.
I am interested to know if anyone has much recent experience of using step-in rights on a commercial development. Given that there are other, possibly more efficient, ways to get projects to completion in insolvency situations (certainly from a funder’s perspective), I would be surprised if there has been a significant increase in their use, even in this difficult market.