UK: Collateral Warranties: Stepping-in

Last Updated: 1 October 2010
Article by Chelsea Walters

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

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 30/09/2010.

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