The COVID-19 pandemic has had an impact on all of our lives and many businesses over the past year but the hospitality industry has been hit particularly hard. Withers have been assisting clients throughout the pandemic with advice on a range of issues relating to hotel development, from advising developers on contractor defaults (agreeing settlement terms and renegotiating existing construction contracts where required) to advising lenders on developer defaults and the renegotiation of facility agreements in response to requests for additional funding.
This note shares our thoughts on some of the issues we’ve encountered so far on current projects and suggests how some of the complications caused by the pandemic may be resolved now and managed or reduced in future projects.
Challenges for Developers
Renegotiation and variation of live contracts
Many of the schemes that we work on are hospitality led, but they are frequently tightly programmed together with residential and/or commercial elements, with residential purchasers or commercial tenants being additional stakeholders. Over the past year we have seen more developers being forced to return to the drawing board to renegotiate existing contracts or revisit their procurement arrangements to enable them to deliver projects in accordance with milestones or completion dates in their project documentation agreed with funders, purchasers and tenants before the pandemic. Alternatively they have actively engaged with these parties to renegotiate and vary their contracts to reflect achievable post-pandemic timelines. It is hoped that these parties will be open to renegotiation and variation of their contracts. If not, developers should take advice on the contractual consequences if they fail to meet their project delivery commitments.
Termination where renegotiation is either unsuccessful or unviable, or in the event of contractor insolvency
If developers are unable to renegotiate contracts, they may choose to terminate the existing contracts so that they can engage a new contractor on more advantageous terms to meet existing commitments to funders and other stakeholders. Developers may also need to terminate where their contractor has run into financial difficulty and is either insolvent or represents a clear insolvency risk. The terms of the relevant contracts should be reviewed carefully and advice sought before any termination action is taken to ensure that the contractual mechanisms for termination are adhered to exactly. Failure to properly comply with the termination procedure set out in the construction contract may itself be a breach of contract. Similarly termination may be a default event under a facility agreement or agreement for lease, so should not be contemplated without stakeholder consultation.
Potential implications for management agreements
Where a hotel management agreement is in place with a third party manager care should be taken to check whether there are any construction milestone dates in the management agreement or technical service agreement. If so it may be that there is a risk that one of these could be missed which would entitle the manager to terminate. It is unlikely that the manager would enforce such a right and quite possible that an owner/developer might be able to rely on a force majeure carve out. However it would be prudent to check and potentially secure a waiver from the manager for certainty, preferably well ahead of the milestone date.
Any proposed delay in the anticipated opening date should be discussed and potentially agreed with the management company as far in advance as possible. From a practical perspective this may mean that the hiring process for the senior management can be postponed.
A tighter insurance market
Developers are facing an ever-hardening insurance market in the wake of the Grenfell tragedy, the pandemic and Brexit. Developers are likely to find that project teams may not be able to maintain professional indemnity and other project insurances at the levels and on the terms they have committed to in the project documentation. We have certainly seen insurance premiums rise and more significant exclusions and limitations be contained in the cover offered at the start of new projects or on annual renewals of existing policies. Depending on the terms of the contracts in place, it may be open to developers to liaise with the project team to contribute towards the relevant members’ premiums to enable cover to be maintained at the higher levels, should the developer (or their lender) require this or to work to agree to continue with a wider level of exclusions. A collaborative approach will make such market obstacles easier to navigate.
Less affordable performance security
Due to the risks associated with the pandemic and Brexit, performance security such as bonds and guarantees may be more expensive to obtain. Performance bonds are treated as project costs, which contractors are likely to price accordingly in a tighter market. Despite the market limitations, developers may nevertheless find that lenders are more risk averse and so insist on performance security being provided. This will leave some developers with no option but to meet the contractor’s increased costs for the provision of such security. Certain lenders may be willing to agree alternative security arrangements, so again, seeking advice is recommended.
Contractors’ reactions to the issues caused by the pandemic and Brexit
Contractors are now more frequently requesting specific additional drafting for their contracts setting out how the risk of the pandemic is to be shared between the developer and the contractor. It will be important for developers and contractors to agree before negotiations become too advanced how additional time and money claims associated with COVID-19 should be managed contractually. Such provisions will also need to be approved by the key stakeholders including lenders and future purchasers.
Challenges for lenders and other investors
Strategies to reduce the risk of developer borrower default
If you are a lender and funding a project which is in a position where borrower default is a concern the terms of your facility agreement should be your first point of reference. The facility agreement will contain lender controls and borrower reporting obligations for your benefit. Lenders should, however, be mindful that developer borrowers may require some lender flexibility to allow room to implement plans designed to limit project cost overruns and delays. Developers equally should be mindful that lenders will expect clear and open reporting if such flexibility is to be given.