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Construction project funding: a return to more rigorous constraints? - International Law Office

International Law Office

Projects & Procurement - Ireland

Construction project funding: a return to more rigorous constraints?

October 06 2009

Introduction
Due Diligence
Building Contract Terms

Collateral Warranties
Conditions Precedent
Covenants
Comment


Introduction

The effects of the ongoing financial downturn continue to be felt keenly in the construction industry. Increased competition, slowdown in activity, decreasing property prices and difficulty in raising finance are some of the major challenges facing construction companies.

As a reflection of the current state of the lending market and the perceived increased risk of borrower insolvency, banks are invariably tightening their lending procedures and are much more likely to ensure that all pre-lending criteria have been met before allowing any drawdown of the relevant funds. The demand for rigorous credit control by lending institutions has consequently led to less flexibility on the waiving of particular terms on individual deals than may have existed previously.

The shortage of available credit for financial institutions on international markets has had a siginificant impact in this regard, with inevitable consequences for projects that failed to secure funding before the lockdown being experienced in the Irish banking sector.

Even where banks are ostensibly willing to provide loans to developers, funding terms have changed radically. Margins and arrangement fees have increased as banks pass on the increased costs of making funds available.

More recently, banks have reverted to closer scrutiny of all stages of the funding process by:

  • completing an exhaustive due diligence process;
  • reviewing building contract terms;
  • obtaining fully executed collateral warranties before drawdown; and
  • paying much closer attention to relevant financial covenants.

Due Diligence

When considering whether to fund a particular project, banks will typically undertake due diligence on the financial soundness both of the project itself and the developer. As part of this examination, banks will require evidence of the developer's financial standing. This may also be required of any ultimate guarantor of the project, the contractor and, depending on the size or nature of the project, possibly subcontractors undertaking key works packages. The construction budget and cash flow forecast for the project will be scrutinized and, increasingly, developers will be expected to justify any forecasts where concerns are raised by the bank. Cost overruns associated with a project are as much a concern for the lending institution as for the developer.

Building Contract Terms

The risk allocation under the suite of building contracts is of obvious significance for the bank and will be closely examined. Any contractual risk assumed by the developer is ultimately a risk for its funding bank, to the extent that it is not assumed or adequately passed down. As part of their general review, the bank's solicitors will be asked to review and comment on the terms of the relevant building contracts, focusing on unusual terms which may be unfavourable to the bank's position. The bank's solicitors will also be instructed to ensure that the usual protection mechanisms are included within the contract from the bank's perspective. In this regard, developers would be well advised to meet their prospective funders sufficiently in advance of the finalizing of the contracts to ascertain the funder's particular requirements. This will facilitate the negotiation of the building contract with these in mind.

Collateral Warranties

The provision of collateral warranties by subcontractors carrying out key subcontract packages is commonplace, particularly in respect of those subcontractors with design responsibility. Collateral warranties are agreements whereby a subcontractor warrants to a third party that it has complied with the terms of its subcontract. Collateral warranties generally also provide a funder with the right to step into the shoes of the developer in the event of developer default.

Developers will be expected to provide a full suite of collateral warranties to the bank. However, in line with the increasing emphasis on credit control, in future there is likely to be a greater emphasis on the provision of these documents as part of the pre-drawdown criteria. Again, developers would be well advised to bear the bank's particular requirements in mind when negotiating the terms of warranties to avoid potential difficulties.

Conditions Precedent

Conditions precedent are clauses in a loan agreement that provide that the agreement, or certain obligations under the agreement, will only come into force if and when specified conditions are met. If a loan agreement is expressed to be subject to a condition precedent, no binding contract will exist until that condition has been satisfied. If only certain specified obligations under the agreement are expressed to be subject to a condition precedent, a contract exists, but the relevant obligations take effect only when the condition is fulfilled.

Conditions precedent to the approval of a developer's finance package typically include the provision of a comprehensive security package to the bank. This can include:

  • a floating charge over the developer's assets ;
  • a standard security over the development site (eg, a mortgage);
  • third-party guarantees of the developer's obligations, including a cost overrun guarantee and an interest shortfall guarantee, provided by a company in the same group as the developer, a director of the developer personally or another financial institution (additional costs may arise for the developer); and
  • the assignment of the building contract, performance bond or other guarantee issued (by the contractor) in favour of the borrower .

Covenants

Banks generally seek to impose various financial covenants on developers when providing funding. A covenant (or undertaking) is simply a promise made by the borrower to do or to refrain from doing something. Loan covenants are designed to protect the funder's investment during the life of the loan and are particularly relevant when a loan will be outstanding for a number of years. They will seek to ensure that the financial condition, business and assets of the borrower remain within certain limits (calculated by reference to debt servicing, cash flows and long term obligations), which formed the basis of the funder's initial credit assessment on the granting of the loan.

Financial covenants in loans should be approached with caution by developers for two reasons. First, constraints and burdens may have an impact on their day-to-day business. Second, a breach of covenant will be an event of default. This may lead to the acceleration of the loan and also to the acceleration of other loans. This may happen if an event of default under any other loan agreement is an event of default under the original loan agreement (ie, if the original event of default triggers a cross-default).

Generally speaking, financial covenants are intended to protect the bank and the developer. Financial covenants are often the bank's first warning of a problem and have become particularly important as a protection against developer insolvency, allowing steps to be taken as soon as a developer's financial difficulties become known.

Comment

Although obtaining finance has unquestionably become more difficult during the global economic downturn, funds must start flowing again as the industry moves through this difficult period. Securing finance will, more than ever before, be based on the bank's satisfaction that all aspects of its pre-drawdown criteria have been met. The consequent shift in balance in favour of the bank will mean that borrowers will have less scope to persuade a bank to deviate from any of these criteria before making a loan available. As a result, increased levels of due diligence and monitoring criteria before drawdown of funds are likely to become widespread. This wider focus on credit issues is likely to delay funding approvals and could result in higher costs.

For further information on this topic please contact Tristan Conway-Behan at Arthur Cox by telephone (+353 1 618 0000), fax (+353 1 618 0618) or email (tristan.conway-behan@arthurcox.com).


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