Construction Lending, Risk and Holes in the Ground 1

Tuesday, August 2nd, 2016
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The building industry is fraught with perils for the uninitiated, lenders included. Together with labour issues and the proliferation of entrepreneurs and speculators, you can find yourself swimming in ominous waters if you are not careful.

The first rule of thumb for the lender is to do lots of due diligence on prospective clients, drilling into their history and determining their track record for delivery. The following questions need to be asked:

  • Have your prospective clients ever been insolvent?
  • What is the building quality like, and does the developer have a reputation for finishing on time and on budget?
  • Does the developer team up with reputable established builders and contractors?

The developer may be sound, for example, but if he/she uses builders that aren’t household names or don’t have a demonstratively good track record, things may become very, very interesting. And as Confucius says, it is a curse to live in interesting times.

Risk has a lot to do with the contracting model. The lender’s risk can be influenced governed by the type of contract. There are many contracting vehicles in the construction industry, such as cost plus, design and construct contracts, construction management and fixed-price contracts.

Cost plus is what it suggests: the cost of the project plus a builder’s margin. This type of contract is repugnant if one has any remote interest in fixed pricing, as there is no certainty and plenty of opportunity for price blow out. It’s great for the contractor, but lousy for the principal.

Lenders generally seek to provide finance on a fixed-price basis and within a fixed time period. Time certainty can be as important as price certainty; delayed completion can culminate in purchaser inspired contract voidability. With cost plus, completion date certainty is illusive. Markets can change overnight and the equity in a project can be wiped out very quickly in a downturn. Certainty is paramount because uncertainty equates with risk.

Lenders need fixed-price and fixed term contracts which are tight, absent prime cost and provisional sums as the latter can turn an ostensibly fixed price into that which  is tantamount to a cost plus contract.

The lowest quote often equals the highest as-built cost

Building costs are currently very high; it’s an expensive process and the margins are low, particularly on the larger jobs where builders are often operating on a two per cent margin. Some builders have told me that this is the “biggest profitless building boom” in history and that doesn’t bode well as the building industry moves towards the end of boom conditions.

Naïve or inexperienced builders often under-quote and the contract invariably goes off the rails.  If a builder can’t complete a project, the cost to complete often escalates by at least 40 per cent. We once acted for an insurer where the builder went into liquidation, leaving a number of multi-million dollar, multi-unit developments half completed. The completion costs blew out by 100 per cent, so be aware that an unrealistically low quote can be ominous. In short, be very careful about entering into a contract where the deal seems too good to be true. If it’s too good to be true, it won’t be true.

Avoid homegrown contracts

The lender should always have a say in the type of contract that the developer enters into with the builder. As a general rule, standard industry contracts such as Standards Australia or MBA and HIA contracts should be used. Purpose-built or homegrown contracts are tailored by law firms to fortify the postion of their own clients and in so doing, they often contain provisions that prejudice the other party to the contract, which will be the principal. Homegrown contracts that are proffered by the builder should be treated with considerable caution.

Remember, the party providing the funds calls the shots, and nothing gets off the ground without money. So, be mindful of the golden rule: he who has the gold rules. As a condition of lending, the lender should insist upon the use of recognised standard industry contracts.

Make sure your tripartite agreements marry

Lenders like to, and should, tie up builders and developers on tripartite agreements. The tripartite agreement is designed to permit the lender to step into the shoes of the developer if the project goes of the rails. However, it is a rare thing indeed to find a tripartite agreement that marries with the head contract. It is paramount that the two agreements are harmonised and “dance” with each other. It therefore follows that the head contract ie the contract between the builder and the principal has special conditions that refer to and “dance” with the relevant conditions of the tri-partite agreement. For instance, if it is a condition of payment of progress payments that the lender’s QS has to inspect and certify payment, then the head contract needs to be amended to reflect that provision. Failing the incorporation of such a provision into the head contract, the existence of such a provision in the tripartite agreement may be a red herring and of little contractual momentum in terms of the legal machinations of the building contract.

It follows that as a condition of tender, the lender should ensure that the contract package that is dispatched to the builder contains the two complementary contractual instruments.

What do you do when the project hits the wall?

In the early 1990s, a great many developers and building companies hit the wall. Banks were left with holes in the ground or partially completed projects. Some sites were ‘black banned’ by unions and by all accounts the projects were not resuscitated until the subcontractors were paid. Such sites often fell into the laps of the banks, which were then left with defunct sites with all of the attendant risks.

If a black hole dynamic presents itself, as a lender you must lawyer up and get specialist legal and accounting advice immediately. When the shark bites, you have to stop the bleeding and very good bandaging is the order of the day to avoid haemorrhaging dollars. The advice will need to traverse IR, insolvency and construction law. A number of complementary yet separate legal skill sets will need to be brought to bear to work out the best solution. Be mindful of the fact that payments made in an insolvency setting will ordinarily be susceptible to claw back laws.

In the late 1990s, we acted for insurance companies that were called upon to indemnify claimants when the builder went into insolvency. Typically, the cost to complete such projects blows out by a factor of between 30 and 100 per cent. Generally, when the administrator went out to tender the completion of the project, it was virtually impossible to get a builder who was prepared to entertain any other contracting model other than cost plus.

So when a bank has to exercise its mortgagee’s rights of possession, it has to exercise greater care. The old saying that ‘the first loss is the best loss’ needs to be borne in mind. Does the bank just sell the property or does it try to finalise the project through an administrator? These are challenging questions, requiring decisions that will be laden with gravitas and decisions that require the deft touch of seasoned practitioners well versed in the polemics of construction insolvency.

How best to utilise your lawyers

In terms of front end, lawyers need to help set up the deals properly. They should know their way around standard industry contracts and know how to marry such a contract to a tripartite agreement.

If lawyers are called upon to assist with a project going off the rails, they need to know not only how to litigate but also the best way to get the damage control outcome. Lawyers need  project management skills. Lawyering in this space requires more than just legal dexterity; it requires a holistic and commercial approach.

Be mindful of the fact that storm clouds are brewing, insolvencies are on the rise and the profitless building boom is coming to an end. Start to think in terms of getting all of your ducks in a row in terms of knowing where to access those rare professionals who know how to stop the bleeding, because my reading of the tea leaves leads me to conclude that the good times are coming to an end and are entering into very, very interesting times.

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  1. David Chandler

    Kim distressed projects are an interesting challenge and I guess we are at that stage of the cycle just now. I seriously question lawyers being the lead in this situation. I have handled a number of these over the years and they all seem to have differing root causes. The simplest will be a developer being forced to on sell a speculative site with DA that cannot get finance for what ever reason. Others will involve a client going broke with nothing to do with the project – remember the Trustees Executors and Agency insolvency, I won't, we were building the Quay apartments in Sydney and owed a progress payment of $2m unsecured, so its not always the builder. In another REMM went belly up on the Myer centre in Adelaide, at the time one of the largest in the state over $50m spent, over 200 people on site, over 40 trade creditors a disaster. I had advised the State Bank prior to their doing a construction lend that REMM did not have the credentials to underwrite a fixed price contract of this nature, but the bank lent anyway. It was one year to the day that I was reappointed to sort out the mess. In Thiery St in Melbourne a name contractor had a D&C to build a $10m serviced apartment project and was a year behind with a claim on the client for over $8m. Not the fault of the client but the client was under the pump from their financier. I was appointed. The constructed quality of the D&C works was non conforming everywhere. I instructed the builder to pull the whole project down and start again. That got his attention – $3m in defects work done at his expense and the claim reduced to $1m. Not enough space here for the forensics of many others. But lawyers were in a supportive role – you needed to know what to do first.