Construction security for funders
Our construction team explores what sort of security banks typically require when providing finance in connection with a construction project.
Construction security
A bank or other similar funder providing finance in relation to a construction project will want to be comfortable that their position is properly protected should the employer (the borrower) get into financial difficulties and find itself unable to complete the project. There will most likely be a lengthy facility agreement in place between the funder and employer describing in detail what constitutes a default by the employer of the funding arrangements. In the event of a default, the funder may want to enforce its security and, as part of this, will want the option of being able to step into the shoes of the employer and complete the project, or employ someone else to do so on its behalf. This option is commonly referred to as a “step in right”.
As with a purchaser or a tenant of a newly build commercial property, the funder will not have been a party to the construction contracts, such as a building contract and the professional appointments, entered into between the employer and the construction team members and will therefore need some other contractual connection with these parties to step-in to the construction contracts or otherwise enforce them.
Security assignment of contractual rights
As a condition to providing finance, the funder may require assignment by way of security of the key construction contracts. Under an assignment, the employer transfers its rights under the construction contracts to the funder. The employer will usually be required to sign notices of assignment when the security is given but the notices may not be served on the contractor/consultants immediately. This means the employer may still enforce its rights under the contracts until the notices are served but also means that if the funder has to take over enforcement of the contracts later on (i.e. if and when it enforces its security) the paperwork is already prepared.
Collateral warranties
A funder may also insist on collateral warranties from the main construction team members, such as the contractor, consultants and subcontractors.
A collateral warranty stands alongside the primary contract, such as the building contract, professional appointment or subcontract, and creates a contractual connection between the funder and the party employed under the primary contract. Under the collateral warranty, the funder has the ability to enforce certain rights under the primary contract against the contractor/consultant/subcontractor (as the case may be).
Typically, a funder collateral warranty will provide the funder with step-in rights, allowing the funder to take the place of the employer under the primary contract in the event of a breach by the employer.
As an alternative to a collateral warranty, the funder might be granted third party rights under the construction contracts. These operate in a similar way to a collateral warranty and allow the funder to enforce certain terms of the relevant construction contract. The third party rights are most commonly set out in a schedule to the construction contract and the construction contract will expressly state that the rights contained in the schedule can be enforced by the third party.
What type of construction security is appropriate?
There are a number of factors a funder will take into consideration when it consider what type of construction security to put in place when providing finance under a project. Typically these factors include the following:
- the relationship between the funder and the employer;
- the financial stability of the employer and main contractor; and
- the size and complexity of the project.
It is common for funders to err on the side of caution and take a belt and braces approach to construction security (for example by taking both collateral warranties (or third party rights) AND a security assignment of the building contract to ensure that it is properly protected in all eventualities.
Please contact Cathrine Ripley in FSP’s construction team if we can help with any of the topics in this note.
