All construction development projects come with inherent risks and challenges – from costs overrun and insolvencies to labour or supply issues. Properly identifying and managing these risks requires skill, planning and prompt good decision-making. Without the correct approach, the risks can crystallise and have a negative impact on the successful completion of a project.
In the economic current climate, developer's are frequently asked questions such as how will the developer guarantee a main contractor's payment for its work? Would there be issues where the developer is using a special purpose vehicle (SPV)? What reassurance can the developer provide by way of payment security?
Common performance security
It is common for a contractor to provide performance security for a project, including by way of performance bonds or parent company guarantees. However, these may not be viable options for developers, especially those such as pension funds, or private high-net worth individuals, who are often commercially unable or prevented from doing so due to industry regulations. A developer may not have a parent company or instead have structured their funds so that each SPV only owns particular properties within their portfolio.
Construction performance bonds are ordinarily granted by banks as a means of insuring an employer against the risk of a contractor's failure to fulfil its obligations for 10% of the build cost – i.e., not for providing developer security. Where developer performance bonds are given, they often involve high premiums , often together with a requirement for a charge to be placed on the developer's other assets.
Escrow accounts
One option is to put in place suitable escrow arrangements. Holding money 'in escrow' would oblige the developer to pay all or a percentage of the total/remaining build cost into a separate escrow bank account. The purpose of the escrow is to provide a fund on which the contractor may draw in the event of an incoming developer's default in making future payments (certified as) due under its building contract.
An escrow arrangement would usually be governed by a prescriptive agreement to minimise or reduce the risk of issues about work performed and money being improperly released. It would usually hold the escrow agent harmless in the event of any disputes around valuation and limit their liability to situations involving delayed payments, mis-handling of funds or fraud.
Escrows would also require the escrow agent to act independently and to operate the account on a purely administrative basis. As such, the escrow agent would typically be the developer's bank, managing agent or solicitors. In the event of a dispute between the parties about a proposed payment, would cause the escrow agent to be unable to act, until resolved by court order or consent signed by all parties.
Feasibility for the developer
As we know, cash in construction is king. However, it would be highly unusual for a developer to deposit the full total/remaining build cost in escrow and usually they would deposited one month's worth of anticipated payment as security, to be drawn down only in the event of late payment.
Conclusion
The current economic climate is challenging on many levels and some projects can be halted by risks or even fail to get started due to concerns over developer solvency. However, whilst it comes with its own challenges, providing security backed by cash in an escrow account is potentially a viable solution to overcome these issues and grant comfort to all parties – and certainly worth exploring.
