Risk, Lending and Damage Control in the Building Industry
By Conjoint Professor Kim Lovegrove, FAIB, Partner of Lovegrove, Smith & Cotton and President-Elect of the Northern Chapter of the New Zealand Institute of Building
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 with Sharks 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 don’t have a good track record then things may not augur well.
Risk has a lot to do with the Contracting Model
The lender’s risk is governed partly by the type of contract. There are many contracting vehicles in the construction industry, such as:
- Cost plus;
- ‘D and C’, i.e. design and construct;
- Construction management; and
- Fixed-price contracts.
Cost plus is what it suggests, the cost plus a builder’s margin. This type of contract should be anathema to the lender as there is no certainty and plenty of opportunity for price blow out. It’s great for the contractor and 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 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.
Lowest Quote often = Highest as-built Cost!
The lowest quote can often translate into 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 3 per cent margin.
Naïve or inexperienced builders often underquote and the contract invariably goes off the railes. If a builder can’t complete a project the cost to complete often escalates by at least 40 per cent. In some cases, law firms have acted for insurers, where the builder went into liquidation leaving 3 multi-million dollar, multi-unit developments half completed. The completion costs blew out by 100 percent. So be aware that an unrealistically low quote is a bad omen.
Avoid Home-grown 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 contracts that are tailored by ‘on the ball lawyers’ for their builder clients should be avoided like the plague. The party providing funds calls the shots, and nothing gets off the ground without money. So, as a condition of lending, the lender should insists 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 off the rails. It is a rare thing indeed to find a tripartite agreement that marries with the head contract i.e. the contract that the developer enters into with the builder.
It is paramount that the two agreements are harmonised and the lender should have a suite of ‘off the shelf’, standard form contracts that are packaged up with tripartite agreements tailored to the standard form agreement.
As a condition of tender, the lender should ensure that the contract package that is dispatched to the builder contains the two compatible and homogenised instruments.
What do You do when the Project Hits the Wall?
In the early 1990’s a great many developers and building companies hit the wall. Banks were left with holes in the ground or partially completed projects. Many such sites were ‘black banned’ and the projects could not be resuscitated until the subcontractors were paid. Invariably banks had great difficulty embracing the notion of paying the subcontractors directly. This was because they had never contracted with the subcontractors. Their contract had always been with the developer. Hence the assumption of a liability that was alien to, and at odds with, the contractual dynamic with an anathema to the banks. The banks were often left with a defunct site with all of the attendant risks. In this environment anecdotal information suggests that some banks felt compelled to pay the subcontractors in order to resuscitate the construction dynamic.
Developer or builder insolvency is financially calamitous. In the late 1990’s, law firms have 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 to does it try to finalise the project through an administrator?
Donald Trump cooperated with the banks in the early 1990’s, and they cooperated with him. With their cooperation he turned things around. It was a testimony to his determination and resolve but also to a non-traditional ‘think outside the square’ approach by the banks. The lesson is treating every case as having its own set of unique circumstances and exercising an escape strategy that is designed to minimise the financial haemorrhage.
How Best to Utilise your Lawyers?
It is very important that lawyers involved in building industry projects have both financial skills and construction law expertise, and that they have a good understanding of the industry. 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 desired outcome. Lawyers also need established project management skills. The resuscitation of a project in the legal sense requires more than just legal dexterity; it requires a holistic and commercial approach.
The Lovegrove Smith & Cotton E-Library is a free online resource of articles, which puts a wealth of information at your finger tips. The articles in the E- Library have been written by lawyers and a number of them have been published in the Australian, The Age and the Herald Sun. Some of the articles date back to the 1990’s. To access click here.
© Lovegrove Smith & Cotton 2014