A step in the right direction

In the current climate, ensuring there are sufficient funds to complete a project is a critical consideration for contractors. This is particularly the case with the increasing use of shell companies, which are often joint ventures that embark on developments funded by third parties. The only asset of the shell company is likely to be the land it is developing – although it may not even have this – and any profit it will make on the forward sale or letting of the development, once built out.

The funder of such a development will be looking for security and protection in the event that the developer is not able to complete the project. The contractor will be looking for reassurance that it will be paid, and the use of advance payment bonds has been on the increase as “money in the bank” to cover one or maybe two valuations. At the other end of the scale are the parent company guarantees and performance bonds that are linked to claims for damages rather than the completion of a job. There is, however, another potentially more comprehensive solution: “step-in” rights.

The collateral warranty that the contractor grants to the funder may give the bank a right to step in to the building contract before the contractor would otherwise have terminated it. A typical step-in provision provides that before the contractor can terminate the contract, it must first give notice – typically about 20 days – to the bank. This allows the bank to either:

• Remedy the breach (usually a non-payment) without doing anything more in relation to the building contract, so the ground for termination disappears in the meantime

• “Step in” to the shoes of the developer in the building contract. The bank will then typically be obliged to pay all sums due under the contract both past and future. The contractor cannot then terminate for that default. The bank will then have the contractor complete the works so that it has maximised the value of its asset.

If the bank exercises either option, then the contractor’s problem is solved – it gets its money. The main feature of a standard step-in provision is the obligation on the part of the funder to pay all outstanding sums due at the point of step in. Parties are, however, free to agree different terms. It is not uncommon to find provisions that limit the bank’s obligation to pay historic liabilities to those that the bank was aware of at the point of step in and sometimes there is a cap on such liability. This is something the contractor should watch out for when agreeing to such provisions. For example, if the contractor is aware of subcontractor claims but has not yet passed these up the line and the bank is not aware of them, the contractor could find itself with a shortfall in funds even after step in. The contractor also needs to be aware that any loss and expense claims will still need to be proved.

Whether the bank will step in and help the contractor will depend on a number of factors. These include:

• The stage the project has reached

It is not uncommon to find provisions that limit the bank’s obligation to pay historic liabilities to those that the bank was aware of at the point of step in

• The complexity of the construction, the use of specialist systems and so on

• The level of contingent liabilities and the cost to complete.

Full information on all of this will be required by the bank before it makes a decision. For example, the bank may consider that continuing with the same contractor and subcontractors is beneficial to the ultimate value of the project.

The complexity of the design, the use of performance-based systems and the involvement of specialist subcontractors will be factors that point to a benefit in continuing, as far as possible, with the same contractor and subcontractor. The need to have performance and product guarantees at the end of a project may also weigh in the mix. However, the overriding factor is likely to be the level of contingent liabilities and overall cost to complete.

So what should the contractor do while the bank is making up its mind? The contractor’s right to suspension may have been unaffected by the step-in agreement. There may also be reference within the step-in provisions to payment for works being undertaken by the contractor during this period of limbo.

All of this underlines how important it is to scrutinise the terms of the step-in provisions at the outset. It is vital that the contractor understands whether, for example, there are any restrictions on the bank’s obligations to pay even in the event of step in, and the contractor’s right to suspend.

There have been very few occasions reported where banks have stepped in to major construction projects. Whether this will continue, given the current state of the market, only time will tell.