The Provision of Security Under Development Leases 0 Comments

The Provision of Security Under Development Leases

Proposition:  Where a long development lease permits multiple redevelopments, the lease should require a developing tenant to provide the landlord with security before commencement of the redevelopment.

I touched on this subject in an earlier post “Tenant’s Right to Carry Out Improvements II”.  To recap, in that post I suggested (for the reasons I gave there) that a long development lease should permit multiple redevelopment subject to conditions controlling the development.  I suggested that these should include “a requirement for the developer/tenant either to pass strict covenant and financial strength tests, or to provide security for the cost to the landlord of completing the redevelopment should the tenant fail during the development period, at worst leaving the landlord with a hole in the ground …”

This post provides further commentary on the issue of security.

As I pointed out in my previous post, development leases are getting longer and a term of 250 years is now quite common.  Given (see my earlier post “Tenant’s Right to Carry Out Improvements”) the effect of S.3 of the Landlord & Tenant Act 1927, it may not be possible (or acceptable) to prohibit subsequent redevelopments; it is certainly unrealistic to do so and, I would have thought, unacceptable to funders.

The other trend which is relevant here (and which is not new) is the almost invariable practice of large development groups to “ring fence” individual developments by forming a special purpose vehicle (usually a limited company with nominal capital and no assets other than the leasehold property itself) to enter into the lease.  Fairly obviously, it would defeat the object of this practice if the parent company of the development group were to enter into the lease as surety – one of the group’s objects in this practice will be to isolate the development from its other assets andbe in a position to put the SPV into liquidation should something go wrong with the redevelopment (including a sudden shift in market conditions – or perhaps not so sudden given the lead-in and construction periods for major developments – but also miscalculation of the development cost or defects in the development proposals themselves).

Abandoned DevelopmentThis leaves the landowner (probably an institution and in many cases I have dealt with myself a charitable institution) with a dilemma. The worst case scenario is that the developer (the SPV) could fail in the earlier stages of the development or redevelopment, effectively leaving the land owner with a hole in the ground.  The land owner would have little option (the local planning authority may serve a completion notice, for example) than to forfeit the lease and to secure the completion of the development by another developer, which will at best be very expensive (as another developer will clearly seek to take advantage of the situation in negotiating new terms) or at worst (if the reason for the failure of the original scheme was due to market conditions) impossible.

Construction Site

The comments which follow may not apply so much in the case of the initial redevelopment which is to be carried out following the signature of the development lease; the landlord is in a better position then to judge the overall strength of covenant of the developer and to assess market conditions for the duration of the development period.  During a 250 year term, however, a lease is likely to be assigned several times, and seeking to control assignment by any kind of financial “means test” will be subject to all of the difficulties to which I will refer, just as much as to the requirement of security itself.

I suggested in my earlier post that there may not need to be a requirement for security if the developer/tenant was able to pass strict covenant and financial strength tests, but on reflection I have some doubts about that.  In the first place, it is very difficult to devise appropriate tests.  Two possibilities would be to provide that the tenant should demonstrate by reference to several years audited accounts that it has such a degree of financial strength that no reasonable landlord will doubt its ability to complete the work, or that the developer/tenant should have a sufficient credit rating from one of the major credit rating agencies.  However, even if the drafting difficulties could be overcome, I cannot think of any possible test which would be likely to be satisfied by a newly formed limited company SPV.

The Rating ProcessVarious questions follow, none of which are easy to answer.  The first and most obvious is; what form should the security take?  There are not many options.  As already indicated, a parent company guarantee is unlikely to be on offer (and even if it was the parent company itself would have to be subject to financial tests).  In theory, the freeholder could ask for a charge over other land of the developer, but by definition an SPV would have no other land and by charging other property in group ownership the parent company would effectively be guaranteeing the development obligation which again it is not likely to be willing to do.  A cash deposit would be ideal but I would think could be ruled in the majority of cases.  The only possibility that then remains is a performance bond.

A developer will of course engage a contractor to carry out the work and will probably require a performance bond from the contractor; in fact, I think this should be a requirement of the freeholder in the development lease.  However, the normal form of contractor’s performance bond would not provide any security to the landlord.  The answer would have to be either a separate bond provided by a bank directly to the landlord to cover any default of the developer, or what would in effect be a tripartite bond covering default by the contractor or the developer, the benefit of which would be assigned to the landlord (as the benefit of performance bonds are commonly assigned to whoever is funding the development).

The next question is the form of the bond.  My understanding of the market is that demand bonds are now virtually unavailable in the market so the best that could be achieved would be a “conditional” or “security” bond under which the landlord will have to prove damage (which is not on the face of it unreasonable but which would still mean that the landlord would incur additional expenditure in enforcing the bond against an issuing institution which would obviously be keen to keep the payout to a minimum).

Sample Performance BondI believe it would be possible (having checked the market) to arrange for a security bond on the lines suggested even though it would be somewhat unusual.  Any comments from agencies which negotiate performance bonds would be most welcome.

The other issue is the maximum amount covered by the bond.  I think this has to be based on a “worst case scenario”.  If, as I suggested in my earlier post, there is to be provision for recalculation of the ground rent gearing, the estimated development cost will be known but I think that would need to be increased by a significant factor to take account of the additional costs which the landowner would incur in the circumstances postulated; something like 150% of the original estimated development cost might well be appropriate (whether the bond could be extended to cover costs incurred by the landlord in enforcing it I am not sure – again comments from the industry would be welcome).

I am conscious that leases of the kind I am discussing rarely contain provision for security but I think that in omitting them landowners (especially charitable institutions) are putting themselves and their shareholders or beneficiaries at considerable risk, largely, it is fair to say, due to the “ring fencing” practice of major development companies who want to structure deals in such a way that they can avoid the remainder of their assets being tainted by the failure of one particular development.

Conclusion:  Save, perhaps, in the case of the initial development, landowners granting development leases for very long periods which do not absolutely prohibit further redevelopment (and for reasons I have already given I think that is not really achievable or practical), provision should be made on the occasion of each subsequent redevelopment for the tenant/developer to provide security to the landlord to cover all additional costs which the landlord would be likely to incur in the event of the failure of the tenant/development.

 

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