Development Finance – What to look for
One of our most frequently-asked questions from our clients who provide development finance is “What should we expect to receive in terms of construction documentation for the Development?”
The truth is that it varies depending on the type of development and the relationship between you and the Borrower, but the rule of thumb is that all material contracts of which the Borrower has the benefit should be either assigned to you, or a direct contract should be made between you and any party materially contributing to the development.
There are some notable absolutes that you should always require, whatever the circumstances. We’ve set out a list of pointers below to help you to identify what you should expect.
Who should carry out the due diligence work?
We recommend that you appoint a suitably qualified monitoring surveyor to ensure that you receive the security you need from the construction documentation. The monitoring surveyor will need to be able to accurately risk-assess and analyse the technical documentation, and collaborate with your construction lawyer to give you the full picture of the protection the documents offer you.
Design – the absolutes
Collateral Warranties. Where there is a design responsibility, whether it belongs to the contractor, professional consultants or design sub-contractors, you should require a collateral warranty, which is a direct contract between you and the designer. You should examine the contract appointing the designer:
- to ensure that it requires the designer to issue a collateral warranty in favour of a party providing funding;
- to ensure that the contract itself is sound in terms of intellectual property rights, insurance requirements and applies an industry-acceptable duty of care.
Without a solid contract behind it, the designer’s insurers are unlikely to cover liabilities under the collateral warranty.
Your construction lawyer should assist you in reviewing the collateral warranty forms, looking for risks such as limitations on liability (usually in the form of caps or net contribution clauses), availability of step in rights, limits on assignment and inadequate insurance requirements which can trip you up if you need to recover losses directly under the collateral warranty.
In a design and build context, the contractor takes single-point design responsibility, but you shouldn’t rely on the integrity of just the contractor’s design; make sure that you obtain collateral warranties from the contractor’s design sub-contractors too.
"Remember, if the contractor is insolvent, the collateral warranty is your direct route to recovering loss from the other contributors to the project."
An alternative to collateral warranties is third party rights, which are more or less on the same terms as collateral warranties and are issued by way of a notice to the designer.
Letters of reliance are often used instead of collateral warranties for those providing surveys and reports on which designs have been based, or work undertaken. Your construction lawyer and monitoring surveyor should advise you as to which will need to provide letters of reliance.
Professional Indemnity Cover. You should verify the professional indemnity cover maintained by each designer, and ensure that the collateral warranty requires the designer to maintain cover for a period of twelve years. Your monitoring surveyor should be able to advise you on the correct proportion of professional indemnity cover required to cover the design liability.
Building Contract – the absolutes
The building contract is a key document for obvious reasons, and the component parts should be reviewed and assessed in terms of risk. You should usually expect the following:
- A standard form contract such as the JCT or NEC form, properly executed with a set of contract particulars which match the practical requirements of the project.
- A schedule of amendments (if applicable) should be added which vary the terms of the standard form to suit the project and the parties’ agreed terms.
- The Employer’s Requirements and Contractor’s Proposals (in NEC terms, the Works Information) which set out the technical content; what the borrower is seeking to build and how the contractor proposes to build it. Your monitoring surveyor should analyse these documents in terms of buildability and advise on the potential risks.
- Pricing documentation should be included and should be clear as to how the costings have been prepared (e.g. time charges, allowance for inflation etc). The legal terms should set out the process for valuations, certification and retention. Payments (or lack thereof) often trigger disputes, so your construction lawyer should check that the payment provisions are adequate and in compliance with the Housing Grants, Construction and Regeneration Act 1996.
- The programme of works is a key document to look for. If the contractor’s in financial trouble, the inevitable delays and associated costs will speak for themselves, signposting potential investment risks.
- If there are any surveys or reports prepared by third parties which are relevant (such as ground investigation, environmental reports or party wall awards) these should either be included in the building contract or provided individually, with appropriate letters of reliance.
Security – the absolutes
For substantial projects, you should ensure that you obtain at least one form of security under the building contract. Security usually comes in the form of a performance bond from a surety (usually a bank or an insurer) or a parent company guarantee.
Performance Bond. A performance bond usually offers 10% of the contract sum from the surety. It is most valuable in the form of an on-demand bond, rather than an on-default bond, or a bond which operates in the event of insolvency.
Parent Company Guarantee. A parent company guarantee will provide you with the security of the Contractor’s parent company stepping in, usually in the event of default or insolvency. This won’t of course be available if the contractor doesn’t have a parent company, in which case alternative security may be required. If the parent company won’t guarantee the performance or solvency of the contractor, that’s a red flag.
Supply chain solvency. Your construction lawyer should check the solvency of all of the parties providing contract documentation. They should also advise you if any of the collateral warranties have a net contribution clause, which prevents the design contributor from being in the line of fire for design liability claims if any of the other parties are insolvent. This can seriously limit your chances of recovering loss, so they are best avoided if possible.
Your facility agreement should be as prescriptive as possible in terms of the contract documentation you need to see. The conditions precedent to drawdown should require copies of all relevant insurance cover certificates, certified copies of the building contract, professional appointments and surveys etc. and a list of required collateral warranties, third party rights or letters of reliance.
Over the course of receiving the documents to review, you will notice that there are invariably gaps, usually where a party is insolvent or unwilling to deliver a collateral warranty for commercial reasons. The risk involved varies, so you should discuss the alternative options (such as indemnification under the facility agreement, or a cost overrun guarantee), or adopting a more commercial approach with your construction lawyer. Don’t be persuaded too easily to drop a condition precedent to a condition subsequent. The incentive to progress the construction documents drops off once the drawdown has occurred and the contractor is getting paid.
Get in touch
Our Construction team is based in three locations and our experience covers a wide range of investor-related contentious and non-contentious matters.
For more information on this update, or any construction or development related matters, please contact Caroline Watkins.