The High Court case of The Royal Bank of Scotland Plc v Chandra [2010] EWHC 105 (Ch) provides an interesting, rare example of mandatory step-in by a bank pursuant to a collateral warranty. This differs from the usual position of the bank simply having the option to do so.
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The High Court case of The Royal Bank of Scotland Plc v Chandra [2010] EWHC 105 (Ch) provides an interesting, rare example of mandatory step-in by a bank pursuant to a collateral warranty. This differs from the usual position of the bank simply having the option to do so.
Background
The Royal Bank of Scotland plc (the bank) agreed to provide finance to the defendants' company for the acquisition of a property to be developed into a hotel under an amended JCT Standard Form of Building Contract 1998 Edition with Quantities. Costain Limited was the contractor. As part of the preconditions to drawdown of the funds, the bank was granted a collateral warranty from the contractor in favour of the bank. The bank was also granted a debenture creating fixed and floating charges over the defendants' company's business and assets, with the usual power to appoint an administrative receiver as agent of the defendants' company and a first legal charge over the property.
Collateral Warranties and Step-In
Collateral warranties provided by contractors to banks are a
standard feature of construction financing. They give banks a
direct course of action against the contractor in respect of the
performance of the building contract, without which the bank's
security over the building and property might be significantly less
valuable. Typically, they also confer on the bank a right, but not
an obligation, to step-in and take over the building contract as
employer, either itself or through a person nominated by it. In
this way the bank may ensure the continuation of the construction
works by the original contractor, and so avoid a costly
re-negotiation of the contract or the engagement of a replacement
contractor.
However, the unusual feature of the warranty in this case was that,
instead of the step-in provisions conferring a right exercisable
only at the option of the bank, it was a mandatory provision,
requiring the bank to step-in. The evidence made it clear that the
bank had taken the unusual step of agreeing to this because the
contractor had been concerned as to the ability of the
defendants' company to meet its obligations under the building
contract and had refused to enter into the building contract unless
the bank provided some form of security. The bank had not been
prepared to agree an escrow account, but had agreed to a step-in
obligation as an alternative means of providing this security, not
envisaging circumstances in which the defendants' company would
default (on the basis that the defendants' company would be
funded by the bank) and having taken the view that in any event the
bank would be likely to wish to exercise step-in rights in order to
complete the development.
The cost of the development began to rise, and the bank became
concerned as to whether the defendants would be able to complete
the development. The bank therefore appointed administrative
receivers over the defendants' company and assets. The
contractor suspended works and subsequently gave notice that it
wanted the bank to step-in and advised the bank that the step-in
provisions in the collateral warranty were mandatory and not
optional. The bank was apparently happy to step-in (via an SPV
nominee owned by the receivers' firm) on the basis that, since
the development was not far from practical completion, it was
important to retain the original contractor, and that, in any
event, delay in carrying out the works would lead to further claims
even if Costain continued as the contractor.
The Structure
The following structure was therefore put in place in September 2003: the bank nominated the SPV by notice dated 12 September 2003, and in accordance with the terms of the warranty, the bank guaranteed the liabilities of the SPV under the building contract to the contractor. Under a letter dated 18 September 2003, the defendants' company and the SPV also agreed that since the SPV was carrying on the building contract as agent for the defendants' company, the defendants' company would indemnify the SPV against all liabilities. The funding to complete the development was advanced by the bank to the company in receivership. The property was then sold, leaving a large shortfall on the amount due to the bank. The bank therefore brought proceedings to enforce various guarantees given by the defendants in respect of the borrowings by the defendants' company.
The Issues
The defendants argued that its company was under no liability
either to the SPV or the bank after the appointment of the
receivers. Among other things (including undue influence and breach
of equitable duty, which will not be dealt with here), they argued
that:
- by the terms of the collateral warranty and the step-in by the bank/SPV, the defendants' company was completely released from any obligation to the contractor and the bank/SPV was instead obliged to replace the defendants' company under the building contract;
- and although the property remained in the ownership of the defendants' company and any increase in its value resulting from the completion of the building works would accrue to the benefit of the defendants' company, it was the bank and not the defendants' company which was obliged to complete the development;
- and given the two points above, the structure which was put in place in September 2003 was a "sham" since it had the effect of re-imposing a continuing liability on the defendants' company in respect of the building contract which was the very liability from which the defendants had been relieved by means of the step-in.
The Outcome
The High Court found in favour of the bank. The defendants'
company was found to have continuing liability for the costs of
completing the hotel. Among many reasons this was on the grounds
that the bank would have been entitled to recover the costs
incurred in completing the development as "expenses" as
defined in the debenture.
It was also decided that the structure that was put in place in
September 2003 had not been a "sham" since the judge was
satisfied that in exercising its powers to enter into the agency
agreement with the SPV and to borrow money from the bank to
complete the development, the receivers were not acting under the
control of or on the instructions of the bank but were exercising
their own judgement. It was also the intention of the
defendants' company acting by its receivers that, as employer
under the building contract, the SPV should be the defendants'
company's agent and that the defendants' company should be
liable for the further funds it borrowed from the bank. The judge
also admitted that it would have been surprising if the bank were
to be required to fund the completion of the hotel for the benefit
of the defendants' company without recourse to either the hotel
or the defendants' company.
The High Court also made some interesting points about the
operation of step-in along the way. The judge made it clear that at
least in accordance with the terms of the collateral warranty,
following step-in, the defendants' company had no further
rights or obligations under the building contract in respect of
future events, and was not therefore liable in respect of the
completion of the development. The step-in wording in the warranty
stated that the building contract was to continue in full force and
effect as between the contractor and the bank and the SPV "to
the exclusion of the Employer." This has held to mean that the
contract between the defendants' company and the contractor was
terminated.
Comment
Although ultimately on the facts of the case the defendants'
company was found to have continuing liability for the costs of
completing the hotel, the step-in wording in the warranty was held
to have the effect of removing the defendants' company's
liability in respect of the completion of the development following
step-in by the SPV, terminating the original contract between the
defendants' company and the contractor and replacing this with
a contract between the bank, the SPV and the contractor. In
relation to any development finance arrangement,
employers/borrowers, funders and contractors will need to be
careful to ensure that the drafting of all documentation clearly
reflects the intention of the parties as to ongoing liability for
completion of the development.
Reference:Royal Bank of Scotland Plc v Chandra [2010] EWHC
105 (Ch)
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
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The original publication date for this article was 30/09/2010.