Direct agreements secure financing
Contractors should remember that direct agreements can form a key part in the financing bank’s security arsenal and that employers often have little control over the bank’s requirements in this regard, writes Joanne Emerson*.
01 April 2008
The purpose of a direct agreement is to give the financing bank(s) additional security (often referred to as “quasi-security”) over the construction and maintenance of a financed asset in order to protect their interests in the asset and the recovery of the facility loan amount.
This includes any agreements for the off-take of also the products of the asset, such as that seen in the case of a processing plant or facility.
In large projects, the banks will require direct agreements covering all the major project contracts (for example, the concession agreement, the main construction contract, any operation and maintenance agreement, any long-term supply contract and any long-term sales contracts).
With such direct agreements in place, banks can, on deciding to rescue a project in default, step into particular contracts rather than exercising their share security over the borrower. This is likely to be preferable in a defaulting project as in exercising its share security, the banks would have to take on the entire obligations and liabilities of the borrower.
Direct agreements are often misunderstood. Contractors are typically wary of, and often confused about, the additional obligations referred to in direct agreements and the role of the banks during the construction term.
However, it is important for contractors to remember that direct agreements can form a key part in the financing bank’s arsenal of security and that employers often have little or no control over the bank’s requirements in this regard.
The key provisions of a direct agreement can be summarised as follows:
Suspension and termination of the contract – the direct agreement will provide that the contractor will not be permitted to suspend performance of the works or to terminate the contract (which is most likely to be for persistent non-payment by the employer) arbitrarily. Such a suspension has to be preceded by giving the bank a period of notice specifying the breach of the contract that has occurred and stating the action required to remedy the breach (this period is typically referred to as the “cure period”).
The cure period is typically between 90 and 120 days. The contractor will commonly seek to reduce the length of the cure period in order to limit its obligation to continue working without payment. The bank will typically seek the longest cure period possible in order to ensure that it has the best chance of properly assessing the circumstances leading to the suspension or termination event.
During the cure period, the bank will have to decide whether or not it is going to step into the employer’s shoes in order to remedy the default (see below). If necessary, the bank will need time to obtain credit committee approval for the allocation of further funds for the project and/or novate the contract to a replacement employer to rescue the project.
Step in rights – a clause will be included allowing a representative appointed by the bank to “step into the shoes” of the employer/borrower, for example, in circumstances where the employer is in breach of the facility agreement because it is insolvent.
This clause will state that the bank should be entitled to serve notice on the contractor, informing it that it will be “stepping in” and the contractor shall be bound by it, regardless of whether or not it has concerns regarding the validity of the notice.
The step-in period allows the bank the time to assess the ongoing viability of the project. The contractor will not be entitled to suspend or terminate the contract or enforce any remedies against the employer during the step-in period (although contractors will typically require the right to suspend the works during the step-in period unless existing liabilities are paid or the bank gives an undertaking to do so).
Upon receipt of a step-in notice, the contractor will be obliged to continue performance of the contract until the bank’s representative decides to step out of the contract, for example, when a replacement employer has been found.
The clause should also require the contractor to enter into a novation agreement if and to the extent that the bank appoints a replacement employer to take over the contract (contractors will often require the ability to approve the identity of the replacement employer). In theory, however, the bank's representative could continue to administer the contract indefinitely without a formal novation of obligations to a replacement employer.
The bank’s right to remedy – a clause will typically be included which states that if the bank remedies the breach of the contract which has occurred, therefore preventing suspension or termination of the contract (which may involve payment by the bank of monies owed to the contractor by the employer), the default will be taken as if it had never occurred.
The direct agreement may also contain a clause allowing the bank to recoup any money it spends in this process. Alternatively, these amounts will be added to the total of the loan facility.
Winding up the borrower – the direct agreement will typically contain a clause stating that the contractor shall not be entitled to take any action to wind up the borrower or to make it insolvent. This is important as otherwise the contractor could put the borrower into default notwithstanding the other protections in the direct agreement.
Liquidated damages – the bank often requires a clause stating any liquidated damages, which the contractor is required to pay under the contract, will be paid directly to the bank.
This will ensure that the bank receives money which, in circumstances where the works are not completed on time, it may put towards interest on the repayments of the facility.
Assignment – the bank may wish to include a clause prohibiting the assignment or novation of the contract without the bank's express written consent. This is standard provision and will allow the bank the right to approve the identity of any replacement contractor taking into account, for example, the capability to complete the works and its financial standing.
The direct agreement will also include a clause effecting the assignment by way of security of the contract from the contractor to the borrower.
Other clauses that the bank could commonly to include in direct agreements are as follows:
Compliance with the contract – the bank will require the contractor to warrant and represent to the bank that the contractor will comply with the terms of the contract and ensure that the works are constructed in a proper and workmanlike manner in accordance with the contract.
Variations to the works – a clause will typically be included prohibiting the contractor and the employer from varying the works so as to materially increase or decrease the value of the works without the approval of the bank. Alternatively, the bank may accept limiting its approval rights to variations over a certain monetary threshold. This clause is necessary to ensure that the loan facility and/or any allocated contingency amount is not exceeded without prior bank credit committee approval.
Insurance – the bank will require evidence that the contractor has put in place relevant insurances it is required to maintain in the contract. The bank will want to be a named beneficiary under the insurance policy.
The direct agreement will also typically contain a clause regarding the payment of insurance monies. These clauses will ensure the bank’s interest in the works is adequately insured.
The banks will also want to be advised of any alteration to the insurance policies and receive copies of any notices issued by the insurer to the contractor (for example, notices of insurance policies being cancelled or becoming void).
The bank will also want to receive notice of any potential claims made against the contractor’s insurances.
The bank may wish to insist that the insurance monies are paid directly to it in the event of an insured event so that it is able to decide whether to use the insurance money to reinstate the works or apply them towards repayment of the loan facility.
Access inspection, site meetings and practical completion – the direct agreement should include a clause obliging the contractor to permit the bank’s authorised representative access to inspect the works and access to any documents relating to the works, for example design documents.
A clause will also be included to permit the bank’s authorised representative to attend site meetings, design team meetings and project control group meetings (if applicable).
The bank’s representative will also need to be entitled to accompany the employer’s representatives when determine whether or not the works have reached practical completion.
The representative will also need to be able to make representations to the contractor regarding whether the works have achieved practical completion. The bank will wish to be permitted at regular intervals, during the progress of the works, to ensure the works are of an appropriate standard and that the contractor is complying with the terms of the contract.
Payments – the bank may wish to include a clause stating that its representative is entitled to receive and authorise payment claims made by the contractor. This is included to ensure that the bank is fully aware of the progress of the development and aware of the amount the payment requested by the contractor every month, particularly if these amounts are regulated through a drawdown schedule.
Copyright licence – the direct agreement will typically contain a clause granting the bank a licence to use the design documents prepared by the contractor for any purpose connected with the works.
This is to ensure that if the banks are required to step into the contract (for example, due to an insolvency of the contractor), it is able to use the design documentation to complete the works and hence recoup the amount of the facility. The licence should be transferable so that it can be transferred to a replacement contractor which will allow the banks to step out of the contract.
Subcontracts – the direct agreement should contain a clause stating that if any subcontract or consultancy agreement is terminated through the fault of the contractor (for example, where the contractor is insolvent and is unable to make the payments due under these agreements), the sub-contracts or consultancy agreements, as the case may be, will novated to the bank.
This will ensure that when the bank steps into the contract, these subcontracts and consultancy agreements will continue and that any delay caused through the breach or insolvency of the contractor will be minimised.
* Joanne Emerson is a Bahrain-based senior associate at the legal practice of Norton Rose (Middle East) LLP. Legal queries related to the construction sector can be addressed to Norton Rose (Middle East) LLP through Gulf Construction magazine at editor@gulfconstructionworldwide.com.
Norton Rose Group has had a presence in the Middle East for nearly 30 years and has advised developers, lenders, and contractors in relation to the legal aspects of a wide variety of construction and infrastructure projects in the region.
With a combined team located in both the Bahrain and Dubai offices, Norton Rose (Middle East) LLP is able to provide both contentious and non-contentious support to financiers, developers, contractors and specialist contractors in the region.”
