DUE DILIGENCE IS NOW A TWO-WAY STREET
One issue arising from the current development financing market is what unforeseen surprises might be faced by a developer which is fortunate enough to identify a financier (bank or non-bank) willing to finance its project?
In this Alert, we discuss a number of matters we have recently come across in transactions which highlight the importance of taking a closer look at the proposed financing terms beyond the interest and fees being charged such as:
- Conditions precedent
- Review rights
- Events of default
- Default interest
- Enforcement rights
Due diligence is now a two-way street
It is standard market practice that prior to a financier being obliged to provide funding, various conditions precedent must be satisfied by the borrower. Conditions precedent apply to each drawing of funds, with the number and nature of the conditions to be satisfied being different depending on the purpose for which the funds are to be applied.
In the case of development/construction funding, the conditions precedent include:
- confirmation that the required amount of equity to be contributed to the Project by the borrower has been paid;
- the required level of qualifying presales has been satisfied;
- the identity of the builder and the terms of the building contract are satisfactory to the financier; and
- the “as is” and “as if complete” valuations are acceptable to the financier.
Until all conditions precedent for a drawing of funds are satisfied, the financier is not required to advance funds. Accordingly, it is critical for a developer/borrower to understand what the conditions precedent are and ensure they are acceptable and achievable by the borrower in a timely manner.
Delays in satisfying conditions precedent can result in valuable time being lost in meeting critical milestones. This can have knock-on effects to both the financier and the developer. Such effects include delays in reaching practical completion and the risk of purchasers not completing under their sale contracts due to construction and registration of strata plans not being achieved by the sunset date.
The above consequences can also lead to default occurring under the financing documents leading to the financier enforcing its security and charging default interest.
We have recently been involved in a transaction where conditions precedent to the first drawdown have not been able to be satisfied for over 6 months. This can have a devastating consequence to the developer/borrower as well as to the financier if it has already provided funding.
In a recent matter, a developer/borrower obtained approval from a bank with which it had successfully done a number of previous transactions. The previous transactions were documented using a bespoke facility agreement which was negotiated and contained all of the terms of the loan (Facility Agreement).
In respect of the current matter, the bank used a standard facility offer letter which incorporated (by reference) terms of a printed standard conditions document (Printed Standard Terms).
On reviewing the Printed Standard Terms and comparing them with the terms of the Facility Agreement it became clear that the Printed Standard Terms were significantly more onerous than the terms of the Facility Agreement. One of these was the bank’s rights to review the terms of the facility.
Under the Printed Standard Terms, the bank had the right to change the terms of the facility on giving notice to the borrower. This right was not qualified or limited in any way. There were no such rights under the Facility Agreement.
Despite pointing this out to the bank and requesting that the particularly onerous terms not apply to the matter, the bank refused this request on the basis that they would be commercial and reasonable having regard to the good relationship between the bank and the borrower.
Given timing constraints, the borrower reluctantly accepted the bank’s position with its eyes open.
The above demonstrates the importance of knowing what is in a financier’s “standard terms and conditions”.
EVENTS OF DEFAULT
In development/construction matters, events of default include matters relating to the project such as delays in achieving practical completion (PC).
If the financier is of the opinion, normally based on quantity surveyor sign-offs, that there are delays which are likely to mean PC will not be achieved by the estimated PC date in the building contract, the financier may call an event of default and potentially takeover the project.
It is therefore important to negotiate this sort of event of default so that it:
- takes account of any variations to the project approved by the financier;
- takes account of time buffers built into the pre-sale contracts in terms of the sunset dates; and
- is not triggered by a determination of the bank without it first obtaining advice from the quantity surveyor or other relevant consultant engaged for the Project.
The meaning of completion or practical completion in the finance documents should ideally be the same as practical completion under the building contract.
Other events of default also need to be considered to ensure that to the extent possible, they are not triggered unless they relate to material issues.
Default interest is generally 2-3% higher than non-default interest.
Default interest can either be charged when:
- there is monetary default, i.e the developer/borrower has not paid any moneys due to the financier when payable under the finance documents; or
- any event of default has been triggered (whether monetary or non-monetary).
It is our experience that the more common (and, in our view more appropriate) approach is that default interest is only payable on moneys owing. The mere fact that a non-monetary default occurs (while the developer/borrower has not, at that time, been late with any payment) should not of itself result in default interest being charged.
To the extent a non-monetary default is of such nature that it is likely to lead to the Project not being completed prior to the repayment date of the loan, it may be appropriate for default interest to be charged. However, any other non-monetary default should not necessarily result in default interest being payable.
Should default occur under financing documents, the financier is at liberty to demand repayment, terminate the facility and, if repayment is not made (and subject to relevant legislation), enforce their security.
For this reason, the comments above relating to Events of Default are particularly important.
Although these are a financier’s technical rights, practically financiers will often work with borrowers experiencing difficulty in relation to a project to work-out an appropriate way forward. This is particularly so in the case of banks in development/construction financing where the bank will generally not want to take on the responsibility to finish the project.
With the large number of non-bank lenders now participating in the development/construction funding space, the attitude to be taken by such lenders in circumstances of default are likely to be more varied. Some may adopt a similar attitude to the banks while others may not be as tolerant and exercise their enforcement rights sooner.
DUE DILIGENCE IS A TWO-WAY STREET
As you will have seen from the above examples and comments, in the current market due diligence is a two-way street. While financiers are used to carrying out due diligence on their borrowers and projects, borrowers have generally not carried out due diligence on their lenders and may not have reviewed the documents they are requested to sign before signing.
In the current market, borrowers need to give careful attention to a greater variety of matters before signing any indicative term sheet or other document in respect of a development/construction facility.
In addition, they may also want to do some due diligence on their potential financiers to ascertain such matters as the availability of the funds and their attitude to matters such as those referred to above.
If you would like to discuss any of the above please feel free to contact us.
Peter Faludi Consulting
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