Introduction and Background
A weight of debt and an unpredictable market
The latest Cass Business School UK Commercial Lending Report published in May of this year showed that development finance reached £8.8bn in 2018 of which the majority (£5.2bn) was for residential development. Whilst this was slightly down on the previous year it is nonetheless a significant figure and makes up around 20% of total new loan origination for the same period. Bearing in mind the short term nature of residential development finance, this is a big figure.
In the same period, house prices have stagnated and price growth has remained flat against the backdrop of domestic and global political upheaval and economic uncertainty surrounding Brexit. This means that a large number of schemes financed in 2018 will be achieving practical completion and coming to market around now. Figures released in July by HMRC show that seasonally adjusted residential transactions have reduced by over 12% in the past 12 months. In spite of well publicised shortage of stock, demand for housing is inconsistent and pricing still remains high and, in many regional markets, beyond the affordability of aspiring owners. Supply of new homes has not yet reached the critical mass where prices are reducing and home ownership is increasing.
Completed schemes are therefore being released into an uncertain market and unit sales milestones are at risk of being missed with the consequence that loans are not being repaid on maturity.
Default – choosing an approach
Whilst it is not our function as lawyers to analyse the economics or data behind market conditions, we can offer pragmatic advice to lenders as to how to approach situations where development loans are about to fall or have fallen into default and the factors that need to be taken into consideration when making a decision whether to enforce or to work with the borrowers to give them breathing space to revise their exit strategies (and if so, for how long?).
Once we understand what has triggered the enforcement decision and what the desired outcome is - sell the development part built, build the scheme out – with or without the existing borrower/professional team – or refinance via a Development Exit Bridge – we can quickly provide advice on the options available.
Over the coming series of blogs the Fieldfisher REF team will consider the relevant issues and outline how the legal framework surrounding the loan can influence lenders' decision making process.
We will be covering:
- Security and Due Diligence Reviews – establishing the enforceability of the Lender's security and getting a snapshot of the title and planning position to inform the enforcement decision making process.
- If the Lender has exercisable step-in rights, what are the considerations to be taken into account when deciding whether to exercise them? Has the contractor and have the professional team been paid for their work up to date and are they willing to stay on and complete the scheme? Could the contemplated course of action impact the availability of collateral warranties? What about if there are no step-in rights? Are there third party rights which can be exercised?
- Does the Lender have licence to use the design and drawings for the scheme and if so with what conditions and/or limitations?
- Is there a Personal Guarantee and if so from whom? Are there any limitations on the enforcement of the guarantee? Can the Lender anticipate and circumvent any arguments raised by the guarantor against its enforceability/validity? How important is the continued involvement of the guarantor to the viability of the scheme?
- Are there any mezzanine or junior lenders who might be interested in funding the remaining build costs or buying out the senior loan and if so on what terms? What are the intercreditor terms that apply in this situation? Is there a mechanism for equity injections or cash cures?
- Have deposits been paid by off-plan purchasers? Are there any other pre-sales or pre-lets? Where are the monies held and on what basis are they being held? What termination rights exist in those pre-sale agreements and will they be triggered by an enforcement? Does the Lender want to preserve them?
- What are the rights and expectations of the providers of the loan on loan/warehouse funding? What action taken in relation to the underlying loans will trigger a default or other consequence in the Lender's credit lines? Conversely what are the obligations of the Lender as borrower under those credit lines where there is a repayment default under an underlying development loan?
Security and Due Diligence Review
What are the options?
Before considering any enforcement action, a Lender will need visibility as to the options available to it under the security that it holds. A typical security suite should, as a minimum, give a Lender:-
- The right to appoint a Law of Property Act receiver in relation to the Property;
- The ability to appoint an Administrator under a qualifying floating charge (corporate chargors only) if one was taken;
- The right to exercise step in rights via a nominee/appointee under the key construction documents or via some other contractual nexus with the contractor team.
The rights described above should – if they have been validly taken and are properly enforceable – be sufficient to enable the Lender to preserve and/or realise the security for its loan. As the methods for enforcement have been well rehearsed in practice notes and guidance from widely available online resources, we do not intend to run through them again here.
Other practical considerations
So are there other more practical matters which should be investigated at this stage which may not come out of the security review? The nature of real estate development is that the asset will – by definition – change over the course of a loan so there may be issues which have arisen at asset level since due diligence was signed off which are relevant to the decision whether, and if so how, to enforce.
Firstly, bearing in mind that the Borrower and its lawyers might not be engaged or willing/able to cooperate with ongoing due diligence, up to date due diligence information may only be available from public sources – so up to date official copies of the title registers should be obtained and checked for any entries have been made since the date of the pre-drawdown version. Any such entries are unlikely to be registrable dealings if security has been properly taken (due to the restriction on title which protects the priority of the Lender's charge) but could be unilateral notices to protect unit sales contracts or leases all of which help to build an up to date picture of the asset at the time of the contemplated enforcement.
The planning register
Secondly, consideration should be given to raising enquiries with the Local Planning Authority, particularly if enforcement is being contemplated before the development has achieved practical completion. Establishing whether there has been any breach of planning consent and establishing whether conditions and s106 obligations have been observed and discharged up to date may also inform the economics behind the decision whether and if so how to enforce. Similar checks could be carried out with the local highways authority and utility providers to the extent that – as can be the case in distressed situations - project monitoring is not up to date.
Finally, a review should be undertaken of all contractual arrangements (including planning, drainage and utilities agreements) to which the Borrower is a party. Apart from construction documents (which we cover separately in this blog series) this would include any leases pursuant to which the Property is held by the Borrower or licences which permit entry onto adjoining land for the purposes of carrying out works. Even if checked as part of the pre-drawdown due diligence, these should all be re-checked to ensure that any enforcement action will not trigger the ability of the counterparty to terminate those arrangements or to pursue the Lender as mortgagee for performance of any of the obligations contained in them. Whilst rare, it is not unheard of for mortgagees inadvertently to give "back door guarantees" via poorly drafted mortgagee consent clauses in planning, highways and drainage agreements.
It goes without saying that the security review should ideally be undertaken by a different firm from that which acted on the loan origination.
Next up we will cover the practical considerations to be borne in mind when contemplating the exercise of step in rights in construction documentation.