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.
In response to Iain’s blog we’ve also had recent experiences of considering whether the best ways to complete developments were via the exercise of step-in rights or whether alternative methods would provide a better solution. Our experience is similar to Iain’s in that step-in rights aren’t frequently used, for the reasons he mentioned, but they should not be ruled out.
Developer and/or borrower insolvencies are on the increase but in some cases banks can take practical, and some might say brave, steps to support the developer/borrower to achieve a successful build out rather than initiating an insolvency process to realise what assets are available. That was our recent experience following a contactor insolvency which had halted a project and where a separate borrower and developer (albeit connected companies) then stood on the precipice of the project’s collapse. The bank, through two carefully structured re-financings, including direct payment mechanisms to sub-contractors, funded the satisfactory completion of the build and mitigated their significant losses on the project.
However, on a separate occasion a forward purchaser client, having terminated a development agreement on the grounds of default by the developer, wanted to keep the project team together so far as possible and also to preserve the building contract until the end of the defects period with the specific aim of keeping the construction package as clean as possible for future purchasers and tenants. It felt the best way to do that was by exercising its step in rights in a manner agreed with the contractor whereby only a proportion of the developer’s debts were paid off. As Iain says, a bird in the hand can be difficult to turn down by contractors and consultants otherwise facing unsecured debts and so deals can be done outside of or as part of a step-in process.
Safe to say, there are many ways to skin a cat and in complex times a bit of imagination is sometimes required. Better to cater for all circumstances even if you don’t think they may in fact be required.
Rick Atha/Shaun Hill, Addleshaw Goddard LLP
I was very interested to read of Rick and Shaun’s recent experiences. Like them, I would certainly not recommend overlooking step-in rights, but it does seem true to say that a bit of imagination and looking beyond the black letter of your contractual rights may help to realise solutions that are a better fit. And it’s always good to read of projects being pulled round through a bit of lateral thinking!