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Mon August 08 2022

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Bank's step-in rights under a collateral warranty

1 Oct 10 The Royal Bank of Scotland plc agreed to provide finance to the defendants' company for the acquisition of a property to be developed into a hotel under an amended JCT Standard Form of Building Contract 1998 Edition with Quantities.

Costain Limited was the contractor. As part of the pre-conditions to drawdown of the funds, the bank was granted a collateral warranty from the contractor in its favour.

The first finance agreement, executed on 20 September 2000, required a number of conditions to be satisfied before the company was to entitled to draw down under the facility. In particular, security had to be provided in the form of a debenture creating fixed and floating charges over the company's undertaking and assets, a fixed charge over the property and "Collateral Warranties" defined as "collateral warranties in favour of the Bank to be executed by each member of the Professional Team in a form and substance satisfactory to the Bank." Importantly, the "Professional Team" included the contractor, Costain.

The warranty provided by Costain in this case was unusual and fairly unique in that, instead of the step-in provisions conferring a right exercisable only at the option of the bank, it was a mandatory provision, requiring the bank to step-in. The evidence made it clear that the bank had taken the unusual step of agreeing to this because the contractor had been concerned about the ability of the defendants' company to meet its obligations under the building contract and had refused to enter into the building contract unless the bank provided some form of security. The bank had not been prepared to agree an escrow account, but had agreed to a step-in obligation as an alternative means of providing this security, not envisaging circumstances in which the defendants' company would default since the defendants' company would be funded by the bank. The bank took the view that, in any event, it would be likely to wish to exercise step-in rights in order to complete the development.

The cost of the development began to rise, and the bank became concerned as to whether the defendants would be able to complete the development. The bank therefore appointed administrative receivers over the defendants' company and assets. The contractor suspended works and subsequently gave notice that it wanted the bank to step-in. It pointed out to the bank that the step-in provisions in the collateral warranty were mandatory and not optional. The bank was happy to step-in via an SPV nominee owned by the receivers' firm on the basis that, since the development was not far from practical completion, it was important to retain the original contractor, and any delay in carrying out the works would lead to further claims even if Costain continued as the contractor.

The following structure was therefore put in place in September 2003: the bank nominated the SPV by notice dated 12 September 2003, and in accordance with the terms of the warranty, the bank guaranteed the liabilities of the SPV under the building contract to the contractor. Under a letter dated 18 September 2003, the defendants' company and the SPV also agreed that since the SPV was carrying on the building contract as agent for the defendants' company, the defendants' company would indemnify the SPV against all liabilities. The funding to complete the development was advanced by the bank to the company in receivership. The property was then sold, leaving a large shortfall on the amount due to the bank. The bank therefore brought proceedings to enforce various guarantees given by the defendants in respect of the borrowings by the defendants' company.

The defendants argued that its company was under no liability either to the SPV or the bank after the appointment of the receivers. They argued that there had been undue influence and breach of equitable duty, and that:

"By the terms of the collateral warranty and the step-in by the bank/SPV, the defendants' company was completely released from any obligation to the contractor and the bank/SPV was instead obliged to replace the defendants' company under the building contract;

"Although the property remained in the ownership of the defendants' company and any increase in its value resulting from the completion of the building works would accrue to the benefit of the defendants' company, it was the bank and not the defendants' company which was obliged to complete the development;

"Given the above, the structure which was put in place in September 2003 was a "sham" since it had the effect of re-imposing a continuing liability on the defendants' company in respect of the building contract which was the very liability from which the defendants had been relieved by means of the step-in."

The High Court found in favour of the bank. The defendants' company was found to have a continuing liability for the costs of completing the hotel because the bank would have been entitled to recover the costs incurred in completing the development as "expenses" as defined in the debenture.

It was also decided that the structure that was put in place in September 2003 had not been a "sham" since the judge was satisfied that in exercising its powers to enter into the agency agreement with the SPV and to borrow money from the bank to complete the development, the receivers were not acting under the control of or on the instructions of the bank but were exercising their own judgement. It was also the intention of the defendants' company acting by its receivers that, as the employer under the building contract, the SPV should be the defendants' company's agent and that the defendants' company should be liable for the further funds it borrowed from the bank. The judge also admitted that it would have been surprising if the bank were to be required to fund the completion of the hotel for the benefit of the defendants' company without recourse to either the hotel or the defendants' company.

The judge made it clear that, at least in accordance with the terms of the collateral warranty, following step-in, the defendants' company had no further rights or obligations under the building contract in respect of future events, and was not therefore liable in respect of the completion of the development. The step-in wording in the warranty stated that the building contract was to continue in full force and effect as between the contractor and the bank and the SPV "to the exclusion of the Employer." This was held to mean that the contract between the defendants' company and the contractor was terminated.

The effect of the notice given by the bank pursuant to cl.10 was that "the Main Contract shall be deemed (as between the Main Contractor and the Beneficiary) to continue in full force and effect as if in all respects the Main Contract had been made between the Main Contractor and the Beneficiary or such other person as the Beneficiary may nominate to the exclusion of the Employer". As a matter of law, a thing is deemed where it is not otherwise the case. The building contract was deemed to continue in full force and effect, as between Costain and the bank and its nominee, because as against the company it was terminated, as the words "to the exclusion of the Employer" made clear. This was underlined by the following three sub-paragraphs which provided that:

(i) All existing and future obligations of the company are assumed by the bank or its nominee;

(ii) Costain acknowledged all of its obligations under the building contract in favour of the bank or its nominee and:

(iii) The contract continued "otherwise with the intent that the [bank or its nominee and Costain] had been the original parties to the Main Contract". This reflected a clear commercial requirement that there should be only one employer under the contract. The building contract conferred many rights and powers on the employer, and neither Costain nor the bank could sensibly tolerate a situation in which they might be exercised both by the company and by the bank or its nominee.

The Royal Bank of Scotland plc v Chandra [2010] EWHC 105 (Ch) 

Some of the other topics  in this week’s Bliss Books  subscription bulletin:

Using "Reasonable Endeavours" To Obtain Planning Consent

Disclosure And "Date Of Requisite Knowledge"  



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