UK: Collateral Warranties And Step-In: What A Bank Should Know

Last Updated: 19 June 2009
Article by Ian McCann

Collateral Warranties And Step-In: What A Bank Should Know

Banks providing funding for a project need to know that their interests are protected and their options kept open in the event of a Borrower going into administration. Ian McCann narrates the reasons for having collateral warranties and the consequences of a Bank exercising its step-in rights through them.

Collateral Warranties

Seen from the viewpoint of a Bank, a project developer is a Borrower and has a direct contractual relationship with the Bank. In turn, the Borrower appoints his professional team and has a separate, direct contractual relationship with them. In the interests of clarity the Borrower's "professional team" means the contractor and the professionals (such as structural engineer, architect, quantity surveyor, etc) and "construction documents" means the building contract and the professional team's appointments.

At the start of a project only the Borrower has a direct link with the professional team. If this stays as it is then the only way for a Bank to seek redress under the construction documents would be through the Borrower. If the Borrower goes into administration then the default position in the standard forms of building contract and appointments allows the professional team to terminate their contracts with the Borrower. This breaks the contractual chain. In this circumstance the Bank would have to sue the professional team under delict if it has suffered a loss as it has no direct contractual link with the professional team. The simple means of getting around this problem is to get collateral warranties from the professional team to the Bank. These then establish a direct contractual link from the professional team to the Bank.

A Bank's contractual ability to take over, or "step-in" to the construction documents is usually contained in the collateral warranties granted to the Bank by the members of the Borrower's professional team at the start of the construction phase of the project.

Put simply, even if the Borrower steps out of the picture (or goes into administration) the Bank will still have a direct contractual link with the professional team to provide the Bank with an enduring source of comfort.

Basically everyone who is involved in the design and construction of the Project should provide warranties to the Bank.

Essentially, this means:-

  • The Main Contractor;
  • The main design and/or construction sub-contractors; and
  • The professional team, the designers and others appointed by the Borrower.

Certified true copies of the construction documentation, the principal signed collateral warranties and evidences of all insurances should be provided as a Condition Precedent for drawdown of any construction finance.

The Bank now has, or should have, all the relevant construction documents before any money is released for construction of the Project. This means that should administration or a relevant breach of the Borrower's obligations arise then the Bank has the ability to take over the role of the Borrower as employer under the construction documentation, provided the warranties given to it all contain the relevant 'step-in' provisions.

Step-In

If for any reason the Borrower goes into administration or is in breach of its other obligations under the construction documents, the construction documents can fall. The works will then cease and the time that it takes to reactivate them will cause delay to the completion of the works and a subsequent increase in costs. What a Bank needs to be able to do is to take over the role of the Employer as soon as possible in these circumstances to minimise the effects on programme and cost.

This is where 'step-in' comes in.

Usually the warranties will oblige the relevant member(s) of the professional team to give a period of notice to the Bank prior to exercising any right to terminate or suspend (note this is quite important especially where tight timescales are involved) their contract. This notice period is usually around 21 days. The Bank then has the opportunity to serve notice on the relevant member(s) of the professional team requiring them to accept instructions from the Bank as the employer, rather than the original Borrower.

It means that the Bank keeps control of its investment. Of course this will entail costs to the Bank should they step in as they will have to take over responsibility for paying the professional team as the Borrower.

Typically you would look for step-in provisions in all the collateral warranties in favour of the Bank and for these to be activated as follows: -

  1. within 21 days of receiving notice from the granter of the warranty of their intention to terminate or suspend their employment under their respective contracts; or
  2. if matters arise that would cause the Bank to terminate the loan agreement, or any other circumstance where the Bank wants to take control.

If the Bank do decide to exercise their right to step-in this has a number of effects on the Bank: -

  1. the Bank becomes directly liable to pay the professional team in lieu of the Borrower from the date that it serves notice of it's intention to step-in to the construction documents;
  2. the Bank is liable to pay all fees and expenses payable to the professional team that are due and payable (i.e. outstanding) at the time it steps in; and
  3. the Bank undertakes to fulfil the Borrower's non-monetary obligations under the construction documents. This may seem like the least onerous of the obligations but the Bank should be aware that in certain circumstances there may be insurance obligations on the Borrower contained in the building contract that will be inherited by the Bank.

The extent of the Bank's responsibility for pre-existing claims (say claims for additional loss and expense) is really one for negotiation with the professional team at the time.

Whilst the bare terms of step-in clauses require the Bank to pay all of these, it may be possible to try and reach a sensible accommodation with the professional team. This may result in a part payment but would allow the professional team the comfort of knowing that their fees will be covered by the Bank going forward.

The Bank might not want or have the experience or the will to act in the Borrower's place. There are two options open to the Bank in this case:-

  1. take over the construction documents and then assign them to a third party e.g. a new investor buying out and completing the development. In order to do this the Bank needs to be clear that the construction documents do not contain any restrictions on assignation. This needs to be flushed out at the due diligence stage especially as most of the standard forms of building contracts and appointments have some kind of restriction on assignation prior to practical completion of the works; or
  2. appoint a nominee (say a firm of project managers or quantity surveyors) to act in its stead after the Bank has stepped in. This way the Bank keeps complete control of the project without having to run it itself but it should be aware that the quid pro quo for appointing a nominee is that the Bank will have to stand guarantor for the payment of all its nominee's fees and expenses.

It has to be pointed out that although all of these powers are, or should be, available to a Bank, there is a genuine reluctance on the part of Banks to become so closely involved in the construction process and so step-in rarely occurs. Notwithstanding that, step-in remains a valuable source of comfort for Banks, albeit possibly one of last resort.

The mechanics of step-in through the collateral warranties is the same on both sides of the border. There are subtle differences in respect of ownership of materials, but that is a whole subject on its own. Suffice to say that the JCT and SBCC contracts have provisions dealing with this point north and south of the border.

This is a brief outline as to Banks' options in the event of administration or other, relevant breach of the Borrower's obligations arise. The one caveat is that this is all dependent upon a Bank having the right construction product in place. Without that, it's a whole different and very messy (and expensive) ball game.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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