Prove your worth: Net worth test

In recent months, banks have been reluctant to invest in new projects and many developments have stalled as a result. Banks that are still funding construction projects are no longer satisfied with a basic diet of bonds, guarantees and warranties by way of security. They have a new favourite dish: the net worth test. It started by being used in PFI contracts, but we may soon see it in traditional projects as well.

What is a net worth test?

A net worth test is a device that helps banks step in to save projects before it is too late. The test applies to the guarantor – normally, the contractor’s parent company. The guarantor must demonstrate to the employer (with the bank peering over its shoulder) that its net worth (that is, the guarantor’s total assets minus its total liabilities) remains above a required level for an agreed period of time. If the guarantor fails the net worth test, the employer has the right to terminate the building contract.

Why is it different?

Traditionally, a robust guarantee has been central to whether a bank decides to fund a project. Banks often insist that if the guarantee is unenforceable, the employer has the right to terminate the contract. However, in practice it is unlikely that the employer will be able to show that the guarantee is unenforceable until the guarantor is insolvent. By this time, it might be too late to save the project.

The net worth test differs from the traditional approach, because the test gives the bank prior warning that the guarantor may have financial difficulties and the bank does not have to wait until the guarantor is insolvent. As soon as the guarantor’s net worth falls below the required level (which is often significantly higher than the contract sum), the contractor is in default under the building contract and the employer is entitled to terminate the contract. This gives the bank more time to resolve the problem: to negotiate with the guarantor, to demand a replacement guarantee or an increased bond or to terminate the contract. The bank is in a far stronger position than if it had waited until the guarantee was unenforceable.

How does it work?

The net worth test works by allowing the bank to carry out more regular checks than usual on the guarantor’s accounts, so that it can ensure that the guarantor’s net worth remains above the required level. The test requires the guarantor to provide interim financial statements (in addition to its annual audited accounts) on a more regular basis (monthly, quarterly or every six months). Most banks would also insist on seeing supporting evidence and any other relevant information.

This requirement can be contentious, as the guarantor may be reluctant to disclose such sensitive commercial information to third parties. There is usually a tussle between the bank and the guarantor over how often the interim financial statements are required and what supporting information the guarantor is obliged to provide.

The duration of the net worth test varies and it is dependent upon the bank’s perception of risk. Sometimes the test falls away at the end of the defects liability period, and sometimes the test applies for the duration of the guarantee.

All doom and gloom?

On the face of it, the net worth test might appear to be bad news for the contractor as it involves more work. However, it is possible to use the test to reduce overall project costs. This is because contractors have been able to persuade banks to accept fewer security documents by offering a workable alternative. In particular, some banks are willing to accept a net worth test instead of a performance bond. This can be good news for the client, since it tends to meet the cost, and obtaining a bond, especially a performance bond, is becoming more expensive. Clients can also take comfort that the test gives the bank more time to step in to complete the project.

The contractor avoids the residual risks associated with a bond, such as the bondsman’s counter-indemnity, and the contractor avoids having to negotiate the terms of the bond with the bank and the bondsman, which can be time-consuming and expensive. In addition, the test should enable the contractor to retain more control over how the security documents are managed. This is because if the bank has an issue that relates to the net worth test, it will liaise with the contractor. This is not always the case with a bond, as the employer will usually liaise with the bondsman directly.

There is one word of caution: some banks insist that the net worth test is used in addition to the guarantee, the bond and the warranties. This may be a bad deal for everyone: it will lead to more expense for the client and will invariably result in more administration for the contractor.

In conclusion, although the net worth test appears to introduce more administration, contractors can use it to their advantage to reduce the amount of project documentation and to reduce overall costs. It will be interesting to see how this area develops.