Step in Rights

A funder of a development will usually have a right to achieve a benefit in return. This could be that a particular type of product, material or layout is installed, therefore in typical circumstances collateral warranties would be requested by the funder which effectively act as a duty of care to the third party. They enable the third party to make a claim in cases where the benefits are not realised or provided.

There may also be concerns at the point of order whereby the funder has concerns as to the liquidity of the contractor, or even the developer, but they are so far down the road with procurement it would be detrimental to progress to restart the procurement exercise. Instead, they seek to include contractual provisions that would protect their investment in the event that either the developer or contractor becomes insolvent with such provisions including step-in rights.

The use of collateral warranties are common place as they’re often afforded step in rights when negotiated, which afford the ability for the third party to step in and direct the works to completion in order so that the benefit can be realised. Other contractual provisions to achieve a similar effect include the use of The Contracts (Rights of Third Parties) Act 1999 or additional bespoke clauses to the standard form of contract that afford the funder even more rights than either collateral warranties or The Contracts (Rights of Third Parties) Act 1999.

So, which to pick and what protection do they truly offer? How should you invoke their use and what should you seek to avoid when deciding to step in? Also, how is your liability affected if you do decide to invoke step in rights?

The need to step in

At a principle level, it makes sense for a funder to preserve their investment in the event a project becomes distressed by stepping into the shoes of the developer, or likewise the developer steps into the shoes of the contractor to direct the supply chain, pay any sums due and ensure the project is completed.

However, is that organisation set up to deliver what could be a complex project and are they prepared to take on any outstanding liabilities as a condition of doing so? It’s for this reason that, in the case of collateral warranties, the funder will seek to write in substantial exclusions of liability clauses and a premium will be applied for their services should they be required to step in, which they’ll seek to recover later on.

Considering the project could be subject to significant cost over runs and delays in regards progress and outstanding commercial matters, many funders or developers may simply chose not to get involved and proceed to let the developer or contractor enter insolvency. It should be noted there are also other stakeholders at play, for example, future tenants to a development or prospective buyers who were engaged by the original developer and may not be willing to commit with a new developer who may simply want to complete in the fastest time possible and at a reduced level of quality to simply realise a level of return.

Time also plays an important factor in deciding the best course of action. On one hand, how far through the project has until completion will undoubtedly affect your decision whether to step in or not. Your decision on whether to step in would undoubtedly be different If an issue occurs at the outset once you have executed contracts as opposed to a situation where it was 80% complete. Also, from a timing perspective, for step in rights to work there should be a period stated in which the beneficiary (i.e. the lender) must decide in this time window on their course of action.

Delay is essentially prejudicial to the financial outcome of the project and therefore long deliberations are not conducive to either ongoing commercial relationships or minimising liabilities. The supply chain who, before the step-in rights notice is issued, could in effect be working for an insolvent developer, are effectively working at risk and building up bigger liabilities though this hiatus period of activity.

Ensure that when drafting agreements the timescales line up. Check the contractor or subcontractor’s timescales for issuing notices of a breach of contract in regards that non-payments are longer than the step in notice e.g. the subcontractor can put the contractor on a 28 notice that they are stopping works, the contractor can put the developer on notice of 21 days and the step in rights notice can be issued and in effect in 14 days, allowing you the time to redress the situation of non-payment and facilitate progress on the programme.

Options available

Collateral warranties are agreements associated with protecting the interests of the end user. For example, an occupier of a building uncovers a defect that is proven to be as a result of design, but they have no contractual link directly to the architect through the contract in place with the contractor, who may have entered insolvency or caused another material breach. In this instance, via a collateral warranty, they have an agreement whereby they have a right to bring about a claim.

The Contracts (Third Party Rights) Act 1999 enables this right to be created in the original contract. However, with the Contract Act 1999, this right is limited to being able to enforce a term of the contract to achieve a benefit, not the obligations of the entire contract. For example, if there is a particular material to be used, the third party can use enforcement rights to ensure this is provided, but otherwise their options are limited.

The third option is a bespoke direct action step in contractual clause in which you can include express contractual rights to step in an effectively take the full role of the developer or contractor. However, there can be issues here in that you operate as the employer/funder and also the developer, which could see you conflicted in certain decisions.

In terms of what is the best option, it depends on the individual circumstances and the existing relationships between the parties. To agree a collateral with a full or partial step in rights, but one with limited liability in regards pre-existing issues, could take a substantial amount of time to agree and cost to incur. Collateral warranties are used more extensively in the industry, therefore if you already have one with terms agreed, this will speed the process up.

Using the Contracts (Rights of Third Parties) Act 1999 will maintain the rights in the original contract, but it is limited with regards the ability to assign to other parties as opposed to a collateral warranty. For example, the contract could have a requirement to provide collateral warranties, but will not be explicit on the number and to whom, which will favour the developer and funder. Contrast this to the Contracts (Rights of Third Parties) Act that requires you to state who has such rights in the contract and are therefore fixed at the point of award.

Collateral warranties and use of the Contracts (Rights of Third Parties) Act are exactly that – rights and therefore not obligations. If a step in right notice is issued it should contain the option to state that someone will act on the behalf of the funder i.e. if the funder is a bank, they will not have the expertise to project manage a development, so as part of the step in rights they should be able to nominate another organisation to take on this role.

What is your liability if they are used?

If you use the Contracts (Rights of Third Parties) Act 1999, as the beneficiary you can exercise your rights where it relates to a benefit, but you cannot instruct other parties to enforce their obligations. Therefore, either a collateral warranty or bespoke set of clauses should be used if the intent is to step in and direct all operations. Note that by taking on the ability to enforce obligations you must also take on the liability for these decisions.

To negate this risk, you should seek to limit your liability to the period after you have invoked the step in rights and make it clear that you will not assume any liability for any existing claims or claims that may subsequently arise for the period before you stepped in.

Also note that once enforcement action is taken by the beneficiary, the Contracts (Rights of Third Parties) Act 1999 states that consequences in the contract in relation to the enforcement e.g. damages and specific performance, are the responsibility of the third party in the same way they are of the contracting party.

You should make sure the affected party agrees that you can service them a step-in notice. They may be seeking to address the breach themselves or at least inform you how they intend to deal with the breach for your review and possible acceptance. Therefore, if you step in and later seek to recover costs, they may argue that you did not correctly serve the notice and as such contest the claim for additional costs.

Case Law

In the case of The Royal Bank of Scotland Plc v Chandra & Anor (2010) a situation arose whereby the developer, Chandra & Anor, engaged the services of Costain to undertake the build of the development. Costain raised concerns as to the liquidity of the company and its ability to meet its obligations and requested a guarantor in regards payment. Subsequently a collateral warranty was put in place with The Royal Bank of Scotland (RBS), but the warranty was unusual in that it was a mandatory obligation for RBS to step in if the developer breached the contract.

During the construction phase, the costs of the development rose to an extent that Costain raised concerns about the developers ability to pay and so RBS appointed receivers over the developers assets before Costain then suspended works and invoked the collateral warranty clause that required RBS to step in. As noted above, banks are not best placed to deliver construction projects so they set up a special purpose vehicle (SPV), which was in essence a joint venture with the developer, as the project was approximately 80% complete at this stage, and used this contracting vehicle to finish the project.

The SPV was indemnified against all liabilities by the bank such that it could enforce obligations through the construction contract with Costain. Once the project was completed, the bank sought to recover their additional costs from the developer who argued that it was not responsible under the terms of the collateral warranty, which it said required the bank to take over the development and was therefore by default responsible for its own costs. The developer even argued that the completed development remained under its ownership and that any subsequent increase in value was entirely theirs.

Once at the High Court, the case was found to be in favour of RBS on the basis that once the step in rights in the collateral warranty were put into force, the contract between the developer and Costain was terminated. The logic here is presumably that the developer was not liable for the costs incurred by RBS in completing the development, but equally RBS could complete the development and sell it to recoup their investment as they had taken on the role of the developer.

It is probably issues like this which cause the industry to rely on collateral warranties more than the Contracts (Rights of Third Parties) Act as they are familiar and with this established approach comes more certainty in their operation.

Feature image photo by Jukan Tateisi on Unsplash

About Dean Suttling

A member of the Royal Institution of Chartered Surveyors, Dean has twenty years of experience in commercial management and quantity surveying, undertaking roles for contractors, clients, and consultants.