Collateral Warranties are an important means of protection for a variety of third parties who have an interest in construction works, including developers, funders and forward purchasers, for example. These documents provide such parties with a direct contractual right of recourse against construction parties who have carried out works and provided services, such as Contractors, Consultants and Design Sub-Contractors, and are commonplace in large scale development projects.

Often in such development projects, various parties to receive Collateral Warranties require the inclusion of ‘step-in’ rights. Step-in rights provide a beneficiary of a Collateral Warranty with an ability to step into the shoes of another party in certain circumstances, becoming a party to the underlying agreement to which the Collateral Warranty relates (e.g. a Build Contract, Consultant Appointment or Sub-Contract). Such circumstances include, for example:

  • where a Contractor has the right to terminate a Build Contract due to the insolvency or breach of the Employer, in which case a party with step-in rights under a Contractor Collateral Warranty (e.g. a development funder) may wish to exercise its right to step-in;
  • where a Sub-Contractor has the right to terminate a Sub-Contract due to the breach or default of the Contractor, in which case the Employer may wish to exercise its right to step-in under its Collateral Warranty.

Also, there is often an ability for a beneficiary to step-in simply upon issuing notice to a construction party, (regardless of whether there has been a breach or default by the original party to the underlying construction contract or agreement). This is an important mechanism for development funders, for example, who often look for an ability to step-in and complete development projects in the event the developer (as borrower) is in default of the loan agreement.

Ultimately, the aim of stepping-in is to ensure the continuance of a construction project and to protect the interests of the third party with the benefit of the Collateral Warranty.

However, careful consideration should be given to circumstances where there are multiple beneficiaries with rights to step-in – who takes priority?

Provision must be made for the ranking of step-in rights between parties, so that all beneficiaries and construction parties are clear as to who takes priority. For example, in the event of Contractor insolvency, Sub-Contractors may issue notices to both the developer, as employer under the Build Contract, and the development funder of their proposal to suspend performance or to terminate the underlying Sub-Contract. Whilst practically in such circumstances it is unlikely a funder would wish to step-in ahead of the developer, if the developer is still solvent and complying with the terms of the loan agreement, this is often a point of negotiation between developers and funders, and the ranking of step-in rights between such parties can vary depending on the outcome of commercial discussions.

Similarly, for those developments with more complex finance arrangements, and requiring both senior and mezzanine finance for example, often both funders will require the benefit of Collateral Warranties with step-in rights, and in such circumstances often ranking provisions are included so as to ensure the senior funder ranks before, and can step-in ahead of, any mezzanine funder.

In the absence of provisions clearly ranking step-in rights, there can be uncertainty and dispute between beneficiaries with competing interests, and this can ultimately hinder the smooth transition of responsibilities between parties in an insolvency scenario, causing increased delay and cost.

It is important also that construction parties are fully aware of the parties they have granted step-in rights in favour of, and that they are content such parties are of sufficient standing and covenant to step-in to the shoes of the original party and assume duties and obligations in its place. An inexperienced or ill-equipped party stepping-in could expose construction parties granting Collateral Warranties to further risk. Construction parties must also ensure they are familiar with the ranking of step-in rights and follow the prescribed order of priority in the event competing notices are received from beneficiaries.

In summary, step-in rights are an important contractual mechanism for beneficiaries of Collateral Warranties, particularly in complex development projects involving third party finance. Step-in provisions, including ranking mechanisms, should be carefully considered and drafted with the varying interests of parties in mind. If you have any questions about step-in rights or require advice in relation to Collateral Warranties or any other construction agreements, please get in touch with a member of our construction team.



Contributors

Jane McMonagle

Partner

Harriet Rutherford

Senior Associate