Building Insolvencies – Holes in the Ground and What to do When a Project Goes “belly up”
Paper by Kim Lovegrove, Breakfast Forum, July 10 2008
In the building industry, the juxtaposition of higher borrowing costs, break-out prices on materials, in particular steel is indeed unfortunate. This is particularly the case with builders and sub-contractors who invariably enter into fixed price contracts which means that their profit margin will be threatened if there is significant inflation in the construction labour and material dynamic.
You may say “Well what has this got to do with the developer? If the developer has entered into a fixed price and the builders price is overrun, then too bad. That is the builder’s lookout.” This is all very well but if a building contractor or a sub-contractor cannot build for the quoted price then that can put the project at risk. If the builder “goes under” the developer is then faced with real haemorrhage. Or to put it another way, there is a palpable risk of developer insolvency.
In the late ‘90s’ our firm acted for a major insurance company. The insurer provided indemnification for insolvency of builders.
When the builder went “belly-up”, the insurance policy enabled the property owner to claim indemnity under the insurance policy. Hence whatever the increase completion costs were, they found their way to the insurers.
When projects “go under”, mortgagees in possession haemorrhage.
We had conduct of a number of multi-million dollar multi-unit development insolvencies. The completion costs on average blew out by a factor of anywhere between 40 and 80 percent. Reason being when a builder goes “hits the wall” quite often an entirely new contracting team needs to be engaged. If a builder “goes under” on one job there is every chance that the builder will go under on all of its jobs. In one matter that I was involved with, the builder “went under” on three multi-unit developments and the completion costs blew out by many millions of dollars.
The current residential insurance policies do not enable a developer to claim indemnity for the totality of increased completion costs. The limitation was introduced because roundabout 1999 the insurers who underwrote warranty and indemnity organised and “lobbying posse”, of which I was a member, to approach the government with a view to asking the government to amend the insurance gazettes to impose a heavily reduced cap on incompletion cost blow-out indemnity. The insurers in “common song” impressed upon the government that the cost of providing indemnity for blanket incompletion cost blow-outs was unsustainable from an under writing point of view. The government acceded to this imperative, because failure to do so could have placed the mandatory warranty scheme in jeopardy.
The insurers also persuaded the government to exclude developers from the claimant category. The net effect being that developers can no longer claim indemnity from insurers in the event that a builder becomes an insolvent. Successors in title can however. Whether a lender as mortgagee in possession could claim indemnity is an interesting and moot point.
Nevertheless, when you consider that insolvency indemnity as a successor in title for the likes of multi-unit developments was considered to be an uninsurable risk for the insurance fraternity, the audience will have some appreciation of the gigantic losses that are associated with this type of insolvency.
It is also worth noting that when multi-unit development exceeds three storeys, with adobes in each storey, there is no legislative requirement for builders to effect warranty insurance. Further, developers are excluded from the class of potential claimers.
Where there is builder insolvency, there is every chance the contagion will spread to the developer. Why? Because the developer will bear the brunt of the increased completion costs and if the developer is unable to resource alternative funding then the lender will be at risk of inheriting a partially completed project nightmare.
So how can the lender fortify its position in an economic paradigm?
The use of the tripartite agreement
Very effective tripartite agreements need to be in place. Many if not most tripartite agreements that we have seen sadly are severely wanting. And yes, they are agreements that we have seen generated by the banks.
Of course it is critical that the lender can step into the shoes of the developer if the developer “goes under”, but likewise “thinking outside the circle” it could at times be useful if the lender could also step into the shoes of the builder, through an intermediary if there is a dual insolvency, because remember when a project “goes under”, the dominoes topple right down the line.
Any agreement engineered should also give the lender the ability to vet and approve of the head contract. Rarely does a tripartite agreement “marry up” with the head contract that operates between the builder and the developer. When this does not occur there is no “contractual marriage”, no contractual harmonisation and invariably the builder will ignore the tripartite agreement and instead pay exclusive homage to the head contract.
Frankly, the lender should control the head contractor and tripartite packaging, have a contractual suite on board and have a condition of finance that both the developer and the builder have to use the package of the lender’s nomination.
Taking a different approach to risk
When the paradigm changes the method of contract should often change. Everybody loves a fixed price contract where there is no “rise and fall” or cost adjustment indices. Why? Because there is price certainty. The problem with this however is that in a high inflationary environment the contractors under fixed price can be expected to bear too much of the risk, if not unrealistic level of risk. A major project from augmentation to conclusion may take two to three years.
If a labour and material blow out in a given year is unusually high it could eradicate the builder’s profit and therefore put the project in jeopardy.
I am not in a “club of one” with respect to the harbouring of these sentiments. The Financial Review in one story under the banner heading “Construction companies fear impact of soaring steel” in a column by Matthew Dunkley stated, and I quote, “rocketing steel prices could bankrupt construction companies unless a greater flexibility is built into contracts, Master Builders Australia has warned… Brian Seidler, executive director of MBA New South Wales in the same article said infrastructure projects could have long lead times and there could be massive fluctuations in the price of key materials such as steel and concrete between the time of tender and the actual start of work.
Mr. Seidler added that price of reinforced steel in one six month period had risen by about 60 percent. He also opined that “unless there is some flexibility in contracts to allow contractors to cope with the unpredictable building materials costs companies will struggle to survive, and competition in the building sector will take a blow”
In such a paradigm consideration should be given to permitting contractors and sub-contractors “down the line” to claim “rise and fall” or cost adjustment based on a formula that is commensurate with the labour and material index pertaining to the construction industry. Reason being if the project goes “off the rails” because of high inflationary impacts and the lender inherits a “black hole” or 50 percent completed project the cost to complete will be horrific and will be compounded by higher than normal inflation. Note however that in the case of residential or multi-unit development rise and fall provisions are illegal as they contravene the domestic building contracts act.
It is probably open however to incorporate “inflation vulnerable” components of construction like steel as prime costs or provisional sums.
In light of the above, be very circumspect about the financing of contracts where the developer boasts to you that it has “screwed down” the builder on price and has landed the builder with all of the risk. Draconian conditions and a lack of fair and equitable risk sharing could prove to be a diabolical formula in an inflationary environment.
When “things hit the fan”
So what does a lender do when the developer goes under? Having been in the construction industry for more than 20 years, we have been round long enough to remember the early ‘90s’ recession. There was absolute carnage in the building industry, “holes in the ground”, union black bans, defunct developments and so forth.
In those days the saying “the first loss is the best loss” had currency. Yet there were “counter thinkers” like Donald Trump who, at a time of serious vulnerability cajoled the banks into working with him, to work through the malaise and he became the “turnaround king.”
In the early ‘90s’ be it through working with administrators or negotiating with trade unions I gained insights that have been poignant for the better part of two decades. But they will nevertheless be equally apposite in a stressed property paradigm.
It is important for a lender in possession to be able to negotiate with key contractors on the building site. Where one has the juxtaposition of developer and builder insolvency, which is not unusual invariably the subcontractors have been short-changed because monies that should have found their way to the contracting fraternity for whatever reason failed to arrive.
If the bank looks at project resuscitation through administrators and so forth it is axiomatic accord needs to be engineered with the sub-contracting fraternity. This sometimes involves negotiating payments to the contractors directly or more astutely through another medium. If the contractor workforce can remain intact disruption can be minimised along with consequential costs.
Builders charged with the responsibility of completing an insolvency project rarely go for fixed price. Reason being when they pick up a half built project it is very difficult to accurately cost the completion price so they often insist upon project management.
One of the imponderables is how much of the original subcontracting team can be retained. Obviously sub-contractors with knowledge of and intimacy with the project auger well for cost containment.
If the lenders through their administrators choose to complete the project cost plus project management may be the only workable solution. If however this is the election, it is paramount that the lender through it’s various intermediaries have highly experience quantity surveyors or cost controllers that can verify the authenticity of project expenditure.
In terms of dealing with unions, some of the strong arm site “blackballing” techniques of the late ‘80s’/early ‘90s’ may not be in vogue because of the potency of the Australian Building Construction Commission. If there were to be any union intervention of an intermediary persuasion resort could be had to the ABIC.
The critical thing is to have access to the right team of advisors when confronted with project failure. Preferably there will be some “old hands” with corporate memory of the early ‘90s’. A myopic and narrow approach to commercial damage control could prove very costly.
Is the first loss the best loss?
The old adage “the first loss is the best loss” whereby one offloads a project at a heavily discounted price may not be the most cost effective solution. It may be better to work it through, to deploy a SWAT team to complete the project with a view to offloading the as-built product.
For fear of labouring the point the ability to put a SWAT team together comprising seasoned hands cannot be underestimated and it is very import that the lender is plugged into these networks.
A change of the property dynamic requires a change in approach on the part of all key players in the building sector, be they bankers, developers or builders.
The ridiculous level of risk that has been borne by builders under their contracts of engagement, or should I say “instruments of incarceration”, may be sustainable in low inflationary boom times, but not so in an oppressive contracting environment. Risk sharing has to become far more equitable and realistic and the lender should be exceedingly vigilant in ensuring that the developer makes such allowance. To reiterate, if the builder becomes insolvent because of volatile material price escalations, the developer will “take a bath” and the lender a “drenching”.
The “off the shelf” contracts from various precedent banks downtown designed to regulate the contracting affairs of developers and builders, in many key areas could well be redundant, in this market, so there is every chance that there needs to be a widespread change in risk burden philosophy and dispensing with prejudicial terms of contract.
Finally, if the lender is burdened with the mantle of mortgagee in possession it needs to engage in serious cost benefit analysis complimented by an open mind, and intelligent and unemotional approach to commercial solution. And within that configuration, the lender must have access to the best types of advisors possible, be they legal, be they number crunchers, be they seasoned campaigners who have already trodden this path.
Written by Professor Kim Lovegrove