December 20, 2018
Authored by: Ben Jones, Simon Clarke and Claire Wainwright
This article first appeared in Corporate Rescue & Insolvency, December 2018.
- Step-in is a versatile tool which gives a lender the right, in certain circumstances, to step-in to a contract between a borrower and its contractual counterparty, and to perform the borrower’s part of the bargain to keep the contract alive.
- It can have much less impact on the actual project or development than the commencement of formal insolvency proceedings, thereby minimising loss.
- Step-in won’t be right for all situations (or for all lenders) and, where there is distress, additional risk factors need to be brought in to a consideration of the lender’s options.
Step-in is a self-help remedy. It is a creature of contract and, in a finance structure, gives lenders the right, in certain circumstances, to step-in to a contract between a borrower and its contractual counterparty, and perform the borrower’s part of the bargain to keep the contract alive. You often see step-in rights incorporated into project and development transactions, where it may be in the interests of the lender to be able to take action to protect value in the project or the development when the borrower is either unable or unwilling to do so itself so as to preserve the contractual status quo of the project or development.
Step-in can be complicated in distressed situations, where there is a risk of commencement of formal insolvency proceedings and the contractual position is just one of many considerations for the directors of the borrower and its lenders.
Typical Step-In Structure
The step-in right will usually be included in a standalone ‘direct’ agreement between the lender, the borrower and the counterparty, which rests on top of the contractual relationship existing between the borrower and the counterparty under the project agreement, construction contract or development agreement (the ‘contract’). Below is a summary of common provisions of a step-in clause:
- When the right to step-in arises. The right to step-in goes hand-in-hand with the counterparty’s right to terminate the contract. The counterparty will usually be under an obligation to give notice to the lender of its intention to terminate the contract, giving the lender a relatively short period before termination becomes effective within which to step-in (15-30 business days is typical depending on the complexity of the project). The lender may also have independent step-in rights entitling it to step-in if, for example, there has been an event of default under the finance documents to which the counterparty is not party.
- How the step-in right is to be exercised. The right to step-in is exercised by notice from the lender to the counterparty once the right to step-in has arisen. Step-in will usually be subject to the lender satisfying, or undertaking to satisfy, specified conditions.
- Conditions to step-in. These typically include the following conditions:
- that the counterparty cannot terminate the contract by reason of the step-in by the lender;
- that the lender or its nominee assumes responsibility under the contract opposite the counterparty; and
- that the lender must pay to the counterparty any unpaid liabilities of the borrower, and undertake to pay ongoing liabilities, as a condition to the step-in. The step-in right may also be fortified by powers of attorney given by the borrower in favour of the lender authorising the lender to act in the borrower’s name to do anything required in order to effect the step-in.
The step-in right will form part of the framework of contractual documentation between the lender and the borrower. That framework will incorporate indemnities in favour of the lender and its nominees for costs incurred in connection with the enforcement of rights under the finance documents, which may be drafted widely enough to include costs incurred by the lender under the direct agreement. The extent of this indemnity is very important on step-in to ensure that the lender or its nominee has cover for the costs it incurs in stepping-in. The costs and expenses indemnity is unlikely to extend to any funding that the lender has to make available to fund payments to the counterparty required as a condition to stepping-in. Such funding may have to be paid to the borrower as new secured funding or, if the facilities permit, as protective loans. The willingness and ability of the borrower and its board to get comfortable with the incurrence of new indebtedness in a default scenario may present difficulties and be a factor in favour of coupling step-in with the appointment of an insolvency practitioner to the borrower.
Key considerations from the perspective of the lender are the ability for others to disrupt the step-in and the risks for the lender of stepping-in.
By a ‘solvent’ step-in, we mean step-in by the lender or its nominee and not by an insolvency practitioner appointed by the lender. This will normally be the starting point and is an entirely reasonable way for a lender to proceed provided that they have considered all the risks.
A key commercial consideration for a lender considering whether to step-in is the cost of meeting the step-in conditions. A counterparty that has issued a termination notice, triggering step-in, who is asked to confirm what is due to it under the contract, is likely to round up, not down. As mentioned above, and depending on the structure of the finance documents, the agreement of the borrower may be needed if additional funding has to be made available to fund the satisfaction of that condition. Shareholder and third party consents may be required and the directors may be concerned about their personal position if taking on more liabilities in the ‘zone of insolvency’.
If the situation is hostile, there is also a risk of pre-emptive insolvency proceedings being commenced by third party creditors, other lenders, the shareholders or directors themselves. If the lender has first ranking security comprising a qualifying floating charge they may be able to ‘trump’ such action by making their own appointment but the process of doing so will be distracting and time consuming, and could further destabilise the situation. If the lender does not have security, or the step-in rights are held in bespoke circumstances, then the interaction with insolvency proceedings commenced at the borrower level can be difficult, as described more fully below.
Leaving aside the terms of any indemnities in favour of the lender, when the lender steps-in it will be performing the contract. It therefore will, in principle, be responsible for any breaches that it causes. If the lender is a secured lender then it will be subject to duties as a mortgagee, including to act in good faith and to act with reasonable skill and care. Those duties are owed to the mortgagor (the borrower) and any other person with an interest in the equity of redemption (such as more junior creditors and the shareholders). For this reason, step-in rights can often be exercised by the lender or its nominee, which may be a new special purpose vehicle incorporated by the lender for the specific purpose of stepping-in, and ring-fenced from the lender.
As a variation to a ‘standard’ step-in, an insolvency practitioner (most likely an administrator or an administrative receiver, if the situation falls within one of the carve-outs from the general prohibition on their appointment) may be appointed by the lender to do the stepping-in. This can mitigate some of the risks for a lender identified above, most notably the risk of a direct claim against the lender for a breach arising through its own actions post-step-in, and the risk of disruption caused by other parties taking their own steps to appoint insolvency practitioners. It also can open up other options for the lender including for an exit via sale of the project or development to a third party, or an acquisition of the project or development by the lender or its nominee, via a credit bid transaction.
The appointment of an insolvency practitioner is not, however, a step to be taken lightly. The step-in and commencement of an insolvency process will have to be orchestrated carefully to ensure that the counterparty does not inadvertently gain the right to terminate the contract as a result of the insolvency event, and the project or other development documents will have to be reviewed carefully to ensure that they also cannot be terminated. The appointment will also add to the cost and expense of the step-in. These costs will typically be met out of the cash flows from the project or funded by a loan provided by the lender. In addition, an insolvency practitioner may require an indemnity before accepting the appointment, which can bring in through the back-door the liabilities which the lender had intended to pass-on.
What happens if the borrower (or another lender or creditor) commences an insolvency procedure (most likely administration) in respect of the borrower before the lender is able to step-in?
In practical terms, the appointment of an administrator before step-in may be fatal, if for example the counterparty terminates the contract and itself steps-in to the project or development. Even if it is not, the lender’s ability to exercise step-in rights will in practice be curtailed.
The automatic statutory moratorium in administration does not prevent the exercise of step-in rights (provided that those rights are not an exercise of security or other event prohibited by the moratorium, such as the forfeiture of a lease by peaceable re-entry). However, it would be very unusual for step-in rights to be exercised in an administration without the full agreement of the administrator. This is because the exercise of step-in rights is incompatible with an administrator taking full control of all assets of the company, and therefore an administrator will resist the exercise of step-in rights which are contrary to their statutory duties as administrators. For example, the exercise of step-in rights will usually result in additional liabilities being imposed on the company in administration, either directly through the indemnity for costs of step-in, or indirectly through the continuation of the underlying contract that has been stepped into. This is inconsistent with the administrator’s responsibility not to incur liabilities except for the purpose of the administration and will be resisted by them. As mentioned above, it is not uncommon for the lender’s rights to be supported with a power of attorney from the borrower. Although revocation of the power would be a breach of it, in certain circumstances if an administrator decides that breaking a pre-existing contract would be in the interests of creditors generally, he or she may do so and incur an unsecured liability for damages for breach of contract.
The lender may be able to persuade the administrator to step-in as the lender’s nominee. Because an administrator owes duties to all creditors, the administrator would have to be persuaded that there is some upside to the borrower’s creditors generally of stepping-in, or at the very least there is no downside to them doing so. This argument might be cast as loss mitigation as well as value enhancement, depending on the status of the project or development.
Step-in is a versatile tool for a lender to a distressed project or development. It can have much less impact on the actual project or development than the commencement of formal insolvency proceedings, minimising value loss. It won’t be right for all lenders, or all situations and, where there is distress the additional risks need to be carefully factored in to the lender’s options.