Author: Sasha Pirbhai
This article was previously published in Construction News on 29 June 2017 and is reproduced here with kind permission.
A common feature of collateral warranties or third-party rights is a right for the beneficiary (often a funder) to ‘step in’ and take over the developer’s rights as employer of a building contractor or a professional consultant, should the developer breach the building contract or professional appointment.
A key situation in which the right might be used is if the developer becomes insolvent halfway through a project.
Should that happen, the beneficiary may effectively use the right to step into the shoes of the developer to avoid the supply chain falling away: it can pay any sums due, ensure that the project is completed, and thus protect its investment by ensuring the continuous involvement of the supply chain to complete the project.
The theory goes that without step-in rights, picking up the pieces once a project becomes distressed can be difficult, if not impossible, and certainly expensive.
Parties are often reluctant to finish the work of others and, free from any earlier contract, both the incumbent and any replacement often demand a high premium for engaging in the remaining services, sometimes coupled with substantial exclusions of liability.
Being able to step in should ensure, at a delivery level at least, business as usual with these problems avoided.
“The theory goes that without step-in rights, picking up the pieces once a project becomes distressed can be difficult, if not impossible, and certainly expensive”
However, it is often observed that in reality funders hardly ever opt to activate their rights of step-in.
Lenders are not in the business of developing properties. If a bank steps into a contract, it will often have to take on liability for outstanding breaches of the underlying contract as a condition of doing so.
From a commercial perspective, prospective buyers or tenants are likely to have bought into the original developer’s vision for the project and may be reluctant to follow through where a lender takes on the project or looks to sell it on to a different developer.
Stepping into the shoes of its borrower will often be the last thing a lender wants to do, both legally and commercially.
Should it decide to step in, a lender can seek to limit its liability to the period after it has done so. In this way, it will not assume liability for any existing contractual claims against the borrower for the period before it stepped in.
However, it may be a condition that if it chooses to step in, the lender is required to discharge any sums payable but unpaid by the borrower as employer under the development document at the point the lender steps in.
When you look at step-in rights in this context, and add the fact that step-in rights can be some of the most heavily negotiated provisions of collateral warranties, adding time and cost to the procurement process, it is perhaps not surprising that there is a developing trend among some lenders towards not requiring these rights at all.
“For step-in rights to work there must be a period in which the supply chain puts that right on hold while the beneficiary decides whether or not to step in”
It is understandable to an extent that if a project has gone wrong, a consultant or contractor may not want a third party interfering with its right to terminate and leave the project.
For step-in rights to work there must be a period in which the supply chain puts that right on hold while the beneficiary decides whether or not to step in.
During that time it could be working at risk, with no certainty that it isn’t just building up a bigger problem for itself if the prospects of getting paid are slim where the step-in does not take place.
Add to that the likelihood of multiple parties all with the choice of step-in (who probably argued long and hard about who gets first dibs) and the position is far from straightforward.
Where step-in is not considered a practical solution, alternative methods may provide a better one.
In an insolvency context, administrators may be better off agreeing that contractors and consultants should continue to work on the project to completion in return for payment of a proportion of outstanding sums (with the project team then taking their place in line as unsecured creditors for the balance).
However, step-in rights should not be ruled out. Not only do they give certainty of an option which the prospect of renegotiating appointments does not, but once step-in has taken place, the right is transferable.
Being able to put a loop around the existing supply chain and then transfer the right to a replacement developer can be a more effective way of recovering a project.
While it is fair to say that the chances of their being used is very small, for any project where it proves to be the best course of action for keeping the construction package as clean as possible for future purchasers or tenants, rights of step-in can be worth their weight in gold.
Sasha Pirbhai, Associate, Fladgate LLP (firstname.lastname@example.org)