UK: Making Construction Contracts Bankable

Last Updated: 20 January 2017
Article by James Bruce

It is a frequent refrain in negotiations on construction projects that the terms of a contract are not "bankable". In this alert, we consider issues relating to 'bankability', and why those issues warrant early consideration by developers, contractors and lenders.

What is bankability?

Bankability: this rather nebulous term is often used in negotiations to justify tougher contractual terms for a contractor, frequently without any further explanation as to why this may be the case - so what does it mean?

In essence, a project is bankable if lenders (traditionally banks, but increasingly other entities also) are willing to provide finance to the project. To ascertain the bankability of a project or a contract, lenders must take into account its technical, financial and legal characteristics. What this means for a construction contract varies depending on the sector and the nature of the works being undertaken, and whilst comparison to previous deals can be a useful guide, in practice, bankability will be different for each individual project.  

It is challenging therefore to specify in the abstract what will be required to ensure bankability, but certainly, early consideration of relevant issues can speed up negotiations and avoid difficult discussions by removing last minute changes demanded by lenders. Even where the initial construction is not to be debt financed, it is valuable to consider these factors to avoid having to revisit the terms, if financing is put in place at a later stage.

In this alert, we explore some of those key themes of bankability and common ways in which it will apply to a construction contract so they can be considered right at the outset of negotiations.

Bankability: relevant factors

Amongst the contractual suite required for a complex project, such as a power plant or infrastructure development, the construction contract can represent the largest expenditure with therefore the largest potential to cause increased costs or delays to the project becoming operational. As lenders will provide finance to a project in different ways and in different circumstances, the nature of bankability and the factors to be considered in its assessment will differ. 

Some examples of relevant factors are as follows:

  • On non-recourse lending, where debt repayment is dependent on the revenue stream from the project, key issues are potential delays to operational availability, reductions in planned performance or unexpected cost increases - all of which could significantly affect the availability of cash to make these repayments.  Lenders will want to assess potential exposure in these areas and the contractual protection in place.
  • Any entitlement for a contractor to claim relief or costs for force majeure, unforeseen ground conditions, changes in law etc. and also the inclusion of significant provisional sums. These factors can all adversely affect the availability of cash to the borrower and alter the financial analysis of the project.
  • Where multiple contractors are involved, lenders will require comfort on how disputes and interfaces will be managed, and if there is a gap between these contracts, how this will be resolved.
  • The experience of the contractor in completing similar work, its track record, the nature of the product or services being provided, and proven technology in which the lender can have confidence will operate as it should.
  • The credit position of the contractor to meet any liabilities which may arise will be crucial. This will include the availability of parent company guarantees and performance security, and will extend to the suppliers of key components and replacement parts, particularly where the project is dependent on a particular technology such as a solar power project.

In simple terms, the greater the risk allocation away from the borrower, the more bankable a contract becomes. The most bankable forms of construction contract are fixed cost agreements with a single contractor responsible for design and construction matters and a fixed completion date.

Accordingly, the construction contract will come under significant scrutiny by lenders seeking to remove these risks from the borrower and reallocate them to other parties. As lenders will often only become involved in the later stages of contract negotiations, all too frequently, required changes to the terms are landed on the contractor once the contract may be otherwise substantially agreed.

Key terms of the construction contract for lenders

Lenders will review the entirety of the construction contract. The following are just some of the key terms which need to be considered in light of potential financing:

  • Restrictions on assignment or charge
    Banks will be looking to take security over the construction contract entered into by the borrower, so will need to ensure that there are no restrictions on assignment by way of security or charges over the contract. This includes clauses limiting the number of assignments or transfers or requirement for consent by the contractor.
  • Access and notification.  
    A lender may demand access and inspection rights for its technical advisers, as well as those of the employer. This may also include copying notices issued to the employer to the lenders, and also specific requirements for monthly updates or progress reports from the contractor. Although rarely problematic in itself, this can cause administrative burden and delay in arranging testing dates etc., so the obligation needs to be recognised by the contractor and factored in to working practices.
  • Conduct of the works 
    The employer will seek effective working practices and performance of the works; as lenders are removed from the day to day operation of the works, they may however seek further assurances in the terms of the contract as to how the works will be performed. In addition, there may be specific lender requirements as to how the works are performed which need to be included in the contract; taking a specific instance by way of example, providing evidence that the works satisfy the requirements of an export credit agency financing the project.
  • Compensation events
    As noted above, lenders will seek cost certainty and will therefore want to limit rights for the contractor to claim additional time and cost to only a few specifically defined instances which the contractor could not have provided against or controlled. Unusual rights to claim additional cost or relief from its obligations will be scrutinised and resisted, with the aim of the risk being mitigated or borne elsewhere.
  • Liquidated damages for delay or poor performance 
    Lenders will want a clear contractual remedy for delay in completion or, where applicable, the decline in performance of a completed facility. These damages will provide critical revenue to the borrower to be used in debt repayment, and will therefore need to be accessible to the borrower quickly and without prolonged process or dispute resolution procedures. As poor performance may only manifest itself after completion of the works (and therefore after all, or the majority of, payments have been made to the contractor), lenders will often expect a bond to be in place to cover performance damages.
  • Warranty and defect obligations 
    Lenders will want to ensure that robust defect provisions are included, enabling the borrower to remedy a failure quickly if the contractor fails to do so. Where plant and materials are provided by third parties and subject to their own warranties, these will need to be capable of transfer to the borrower with sufficient evidence that these have been transferred.  Including forms of assignment into the contract can be useful to avoid disputes with suppliers at a later stage.
  • Termination rights 
    Lenders need to ensure that the parties are committed to the project, so will seek limited rights for the contractor to terminate (subject, of course, to the direct agreement). Conversely, lenders will themselves want termination rights in order to replace a contractor quickly in case of delayed or non-performance.
  • Testing 
    Lenders require a clear and objective performance requirement to ensure that the works are completed or the plant is operational to the necessary standards, which may be through performance tests. The concept of completion will be included in the finance documents and may cross refer to the construction contract.
  • Insurance 
    Insurance is a critical method used by the lenders to mitigate risks on the project, and they will have specific requirements for the insurance taken out by the borrower and the contractor. Often the contractor will have an interest in the single project insurance taken by the employer, which is assigned to the lenders. Lenders often prefer there to be a single project insurance policy, rather than rely on a contractor's global all risks policy, as this usually enables the employer to "bolt-on" an advanced loss of revenue policy that can provide a debt serving revenue stream if damage causes delay to completion of the project.

    Under the terms of the financing, it is likely that insurance proceeds from material damage will be mandated to be paid to lenders and not necessarily used in the reinstatement of a facility. If this is the case, the contractor will need to be relieved of its obligations to complete the works if it does not receive the proceeds from insurance. Alternatively, the contractor and employer (and lenders) will agree a schedule of payment for how the proceeds will be applied to the costs of the rectification work performed.
  • Cap on liability 
    Lenders will review the limits and exclusions from liability to ensure they provide an acceptable recourse against the contractor.
  • Liability for subcontractors and sub-suppliers 
    Lenders will be likely to want to control who is appointed to perform major subcontracts, and particularly to ensure there is no wholescale subcontracting. The lenders' concern will be to ensure that the contractor would not be in a position to avoid liability due to the actions or inaction of the subcontractors.
  • Payment 
    The payment profile should contain a clear mechanism for the contractor to be entitled to payment, and sufficient time to ensure that the funds will be made available to make such payments. If payment is to be made against specified payment milestones, these must be weighted such that there is a sufficient incentive for the contractor to complete the works to ensure an operational project. Lenders will also resist payment schedules that are "front loaded", requiring payments made to be no more than the value of work done.  Any advanced payments will need to be backed by an on-demand bond for the same amount.

Additional requirements

As part of their financing conditions, lenders may require the following additional contracts/agreements from a construction contractor:

  1. Direct agreement 
    This provides a direct contractual relationship between the lenders and the contractor. There are a number of traps here for a contractor and although it is a common requirement, the request should be considered carefully.

    The direct agreement can be a benefit to the contractor, as it provides a mechanism by which the lender may step in and resolve any default by the employer, particularly on non-payment. It can however cut across the negotiated position in the contract, particularly where there is a long step-in decision period which prevents enforcement by the contractor. It can also impose a separate liability to the lenders in addition to that under the contract.

    Where financing is not in place at contract signature, there may be an obligation to enter into a direct agreement at a later stage, and if this is the case, the contractor should be aware that it may incur further additional costs in negotiating this direct agreement.
     
  2. Legal opinion
    Where the construction contractor or its guarantor is incorporated in a foreign jurisdiction, lenders may require a capacity opinion to ensure that entity has validly executed the relevant agreement (construction contract, guarantee, direct agreement etc.). There is a time and cost to obtaining such opinion which should be considered by both parties, and particularly who may bear the costs of this, if it is not provided at the point of signing the agreement.
     
  3. Finance conditions precedent
    In a financed project, the entry into the construction contract may come under greater scrutiny than may otherwise be the case and lenders will typically require a number of documents from the construction contractor as a condition to the financing. These include board resolutions of the contractor documenting its entry into the contract, and director's certificates confirming the entry into the agreement, its constitutional documents and the passing of the relevant board resolutions.  It is worth considering these issues early to ensure that they are dealt with efficiently and do not become a constraint on achieving financial close.

Bankability - art or science?

There are many ways in which a construction project can be considered "bankable", and lenders' requirements change depending on the structure of the project, the risk appetite of the lender and the identity of the parties involved. From a practical perspective, even where the initial works are not bank financed, if financing is to be introduced at a later stage, (say post-completion during the defects liability period), it is worth considering these issues early in the discussions to avoid costly re-negotiations and surprises.

When negotiating contracts in financed projects, each party should consider how the structure may be affected by the lender requirements.

Contractors

Be aware that the employer's ability to negotiate an agreement and agreed terms may be constrained by their lenders.  Consider the obligations which lenders may require, and ensure that the administrative provisions and costs of negotiating legal opinions, direct agreements etc. are taken into consideration.

Developers and sponsors

To reach a commercial agreement can be a delicate balancing act between negotiating with contractors and the often opaque requirements of lenders. Taking into account the bankability concerns will help to negotiate bankable documents, whilst early engagement with lenders can be useful to ensure that provisions are not agreed with contractors which subsequently require amendment as a condition to financing.

Lenders

A robust bankable structure on the construction side will be a key requirement of credit approval. The finance agreements will need to take into account the terms of the construction documents, but as noted above early communication of requirements to the construction contractor particularly over conditions precedent can avoid unnecessary delays with the contractor struggling to obtain relevant documents in the timescales demanded. 

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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