Dubai Law No.(8) of 2007 On the Matter of Escrow Accounts for Real Estate Development (the Escrow Law) was issued to regulate developers and safeguard purchasers’ money in respect of off-plan property purchases in Dubai. However, recently there have been cases where purchasers have been left without recourse to claim return of payments made where the project they invested in failed to complete. Ashraf Sayed examines the protections the Escrow Law offers to purchasers and whether the Escrow Law has succeeded in its objectives.
In brief:
The Escrow Law does not guarantee the completion of a project or the full security of a purchaser’s money placed in escrow.
If a project faces completion difficulty, the relevant authorities have the power to preserve the rights of the purchasers, but have until now taken limited action against non-escrow compliant developers.
Penalties are set out under the Escrow Law allowing the relevant authorities to levy fines and/or seek imprisonment of those who breach the Escrow Law.
Introduction
The real estate boom in the UAE commenced in 2003, however, the Dubai Escrow Law was implemented in May 2007 and required developers to be in compliance by early 2008. There was therefore a period of four years where developers were essentially unregulated in relation to funds received from purchasers.
Generally, the Escrow Law:
applies to all projects currently under construction and to all future projects where funds are to be collected for off-plan sales
requires one escrow account for each project
restricts developers from utilising purchasers’ funds for purposes other than the project
contains provisions to control and limit “start up developers”
provides penalties for non-compliant developers, which include criminal liability and de-registration.
Despite the Escrow Law being in force for over two years, some confusion remains within the market as to its practical application. So where do purchasers and developers stand?
Does the Escrow Law guarantee project completion?
The Escrow Law does not guarantee project completion. There are a number of reasons for this:
1. If a purchaser invested in a project that could not be delivered due to the project’s viability or the reputation or financial credibility of the developer, then the Escrow Law may be of limited assistance to the purchaser.
2. Prior to the enactment of the Escrow Law, matters between real estate developers and purchasers were addressed in contracts and prevailing law. More often than not, the contract did not specify that the monies would be held in escrow to be used only for the construction of the project or that a particular stage of construction must be reached before the next payment was due, although it is arguable that this is implied within the contract. It was therefore possible, in such a self regulated environment, for developers to use purchasers’ funds for uses other than the construction of the project.
3. Under the Escrow Law, developers had to submit a number of documents to the Real Estate Regulatory Authority (RERA) prior to opening an Escrow account and thereafter the developer had to meet certain criteria before being allowed by the Escrow trustee (a bank approved by RERA) to withdraw monies from the Escrow account. It is still unclear whether this process had been properly undertaken and was being fully enforced and also what mechanisms were put in place to properly test the viability and feasibility of the project before money was allowed to be extracted from the Escrow account. A related concern was that some Escrow trustees may have permitted release of certain funds without appropriate supporting documents. In the initial stages post-Escrow Law, and most certainly during the property boom, it could be argued there was a relaxed attitude towards the withdrawal of funds from escrow accounts by developers with limited sanctions imposed by RERA and the Escrow trustee. Some projects have run out of liquidity as monies in Escrow had been depleted either on non-project related expenditure or where released payments were greater than actual expenses.
4. Even where a project has an Escrow account, if the number of defaulting purchasers is high and the developer has no other source of financing, the project may not be completed as periodic liquidity requirements may not allow contractors to be paid, leading to a halt in construction. This is typical of projects where sales were made to bulk purchasers who were often real estate agents or speculators wishing to make profits from quick re-sale.
It is worth noting that, under the Escrow Law, if conditions exist which prevent the completion of the project, the relevant authorities can take steps to preserve the rights of the purchasers in order to ensure completion of the project. Clearly this might not be possible if the funds in the Escrow account have been depleted through questionable disbursements, but it can be utilised to increase the protection offered to purchasers.
Do Escrow accounts safeguard investors’ interests?
If Escrow accounts are administered correctly, purchasers’ funds should be secured to the extent they should only to be used for the development of the project to which they relate. These funds are secured generally to the extent that the money remains in the Escrow account, however, as soon as the funds are depleted, purchasers may become unsecured creditors to the developer.
In circumstances where the developer cannot complete a project, the Escrow trustee can, after consulting with the Dubai Land Department, either replace the developer in order to complete the project or refund the amount in the Escrow account paid by depositors. The mechanism of determining who gets access to the funds and in what priority is not clear especially where a project financer (ie bank) is also involved. Furthermore, it is not clear whether there have been any projects officially cancelled by RERA or an Escrow trustee due to the inability of the developer to continue with the project or due to non-compliance with the Escrow Law.
At the current time, any premium monies paid to a previous purchaser in a secondary market transfer will be paid direct to the previous purchaser and will not go into the Escrow account. Should a project fail, it is highly unlikely that any premium paid to initial purchasers will be recoverable by subsequent purchasers.
Misuse of funds and penalties
The Escrow Law clearly states that the Escrow account is to be used solely for the purpose of developing the relevant real estate project and the deposited funds may not be attached for the benefit of the creditors of the developer. Article (9)2 of the Escrow Law specifies that should the developer carry on more than one project, a separate Escrow account must be opened for each project.
The Escrow Law is also subject to the provisions of the Trust Account Regulations for Law (8) of 2007 (Regulations). One of the basic concepts of the Regulations is that money may only be released from an Escrow account in accordance with the provisions of the Regulations. The Regulations set out a range of expenses for which funds in Escrow can be used for and which generally relate to development costs, and other related expenses such as marketing for the project.
In addition, Article (404) of Federal law No.3 of 1987 (Penal Code) makes it a criminal offence for a party who has been given funds on trust for a specific purpose to use those funds for another purpose, which is essentially a breach of trust and could be fraudulent. There are a range of criminal penalties for breaching the Penal Code.
With reference to the Escrow Law, penalties are set out that allow the respective competent authorities to levy fines and/or seek an order for terms of imprisonment against those who breach these laws. If there has been a violation by any party of the Escrow account laws then, without prejudice to any punishments stipulated by other legislation (for example the Civil Code or the Penal Code), fines and/or imprisonment may be imposed. Such breaches cover a wide range of issues, including embezzlement or use without justification of funds collected for the construction of real estate projects.
Regulation of accounts
The Escrow trustee is obliged to provide RERA with periodic statements of revenues and payments from the Escrow account and RERA may request the Escrow trustee to provide information or documentation which it deems necessary for review. Furthermore, RERA may appoint auditors to review this documentation.
The relationship between RERA is also subject to the terms and conditions contained in the contract. This includes how often the Escrow trustee provides financial information to RERA.
If RERA finds that the Escrow trustee has committed a violation of the Escrow Law or its implementing by-laws, it shall serve a notice to the Escrow trustee and provide a grace period for the rectification of such violations. In severe cases, fines and/or imprisonment may be imposed.
Conclusion
A number of property related laws have been enacted in Dubai over the past four years to not only protect purchasers and developers, but to encourage development within the Emirate. As speculation about market recovery grows, and purchasers return to the market, discussion of applicable measures to protect investments naturally emerges. The Escrow Law is only effective if it is adhered to by developers and appropriately regulated by authorities. A number of recent cases have shown the potential abuses and penalties associated with misuse of Escrow funds. But recent improvements such as RERA’s policy of 100% payment for land prior to the launch of a new project and construction based payment schedules are sensible and necessary. There are likely to be further improvements in the future.
Many aspects of the future banking landscape will certainly be different from before, but in the “old banking toolbox”, there remains at least one tried and tested methodology for managing lending risk, namely the effective use of financial covenants by lenders and borrowers. In the new world, if effectively used as a management tool by both parties, financial covenants will arguably have even higher importance than before.
In brief:
Using financial covenants as an effective management tool provides the glue which binds a lender and borrower closely together in managing their respective risks during their relationship
Lenders, borrowers and their professional advisers should endeavour to ensure that the financial covenants are drafted with absolute clarity, but equally with sufficient elasticity, to nurture and safeguard the overall health of their relationship
To this end, lenders and borrowers should consider two or three tiers of financial covenants, with increasing levels of sanction for breach, but not every breach automatically triggering an event of default
Financial covenants are not just for large corporates. The principles behind using them apply equally to small- and medium-sized businesses.
Once upon a time, a company with a good business model had access to two principal sources of external capital to support and grow its business: share capital (equity) and loan capital (debt). A good business would also have access to a third form of capital, internal capital (retained profits). Management could then use these three “sources of capital” to fund the company’s future activities.
Leverage (or Gearing)
Most companies cannot source their capital from shareholders' funds alone and need some element of debt. Financial principles suggest that higher financial leverage can be both good for the business and good for the shareholders in good times, but not so good in bad times. Conversely, in good times, the absence of financial leverage may make it very difficult for a good business to grow and to take advantage of current market opportunities then prevailing. The same principles apply to operational leverage as they do to financial leverage.
Unfortunately, the global financial crisis threw into sharp focus what happens to the financial accounts of a company when the “second tap” to capital (loan capital) is switched off, the “third tap” (retained profits) moves quickly to be closed, and the “first tap" (new share capital) remains open but there is nothing available in the pipe. The global financial crisis has provided a timely moment to re-think the basic characteristics of lending by a lender to a borrower. What goes to the heart of the lender borrower relationship and drives that relationship from its inception towards a mutually beneficial arrangement and hopefully longevity?
Furthermore, in tougher market conditions, a good company should maintain a lower level of leverage to counter-balance lower levels of profitability (and, therefore, potential retained profits) and to preserve the value of shareholders' equity. Using the oft-quoted car example to explain leverage, a good business needs to be in the right gear at the right time to suit the prevailing market conditions. Permanently driving down the fast lane in top gear in all conditions and, therefore, not being able to change direction quickly if an obstruction suddenly appears is generally a recipe for an accident waiting to happen.
Management at the wheel
But how does a good company steer its business safely along "Leverage Highway"? A good management team drives a good business, but a good lender helps to drive a good management team by being available in the front or back seat with a clear view of the driver. The lender has a joint responsibility with the borrower to make the relationship a successful one. The lender will be able to nurture the relationship by agreeing a set of financial covenants which serve the interests of both parties in helping each manage their respective risks. It is important for each party fully to understand the nature of each other's business interests and, particularly, what returns and added value each earns from the relationship.
Management without committed long-term loan capital is a higher risk activity
Apart from very cashflow-strong and very cash-rich businesses, few companies with loan capital on their balance sheets could be described as financially strong businesses, if their only instrument of loan capital was "on demand" loan capital (i.e. a “current liability” in accounting terms). From a financial accounting perspective, such businesses would have to be characterised as higher risk and more inherently unstable. A lender’s commitment of only "on demand" loan capital conveys a message to the borrower that the relationship may only be short-term in nature. For the borrower’s management, obtaining committed long-term loan capital is invariably an essential component in running a successful business.
Doing committed business
Once a supplier (the lender) has won a customer (the borrower), in most cases, it is much easier for the supplier to do repeat business with the customer than go out and find a new customer. In fact, it is preferable for each party to be viewed as both a supplier and customer at the same time, which reinforces the message that the borrower is offering to supply to the lender its business by way of giving the lender the opportunity to participate by way of an investment in its loan capital.
The costs in the relationship
The cost of the lender borrower relationship is more than just the cost of funds and the arrangement fees and commitment fees payable by the borrower to the lender. A well advised borrower should be looking at the total cost of ownership of being in a relationship with a particular lender. If financial covenants are indeed the glue which binds the borrower and lender together in managing their respective business risks during the relationship, then the borrower and the lender need to be on exactly the same page when it comes to calculating the financial covenants and then analysing and interpreting their true meaning for the business going forward. The value proposition in a borrower choosing one lender over another is that the borrower perceives the first lender as having a better understanding of the borrower's business than the second and further that the borrower perceives that the first lender will be more supportive of the borrower in those times during the relationship when, as in any relationship in life, issues arise and things may become difficult and need to be sorted out.
Contractual knot between the parties
The lender and the borrower are contractually bound together by a short-form or long-form of loan facility document. This loan facility document may or may not be supported by a guarantee and/or security documents. However, what most cements the relationship between the two parties, and its capacity to be a long-term relationship, is not the availability or otherwise of good security, which can be enforced on a default or on demand. Rather, what most cements the relationship is the holy triumvirate of the following clauses and their sensible use and interpretation by each party, especially the lender:
1. representations and warranties, which cover the position pre-consummation of the relationship and either validate or disprove the commercial and legal due diligence carried out by the lender prior to provision of the loan capital. In short, a breach legitimately entitles the lender to end the relationship and the borrower should have no complaints if this happens;
2. undertakings, both positive and negative, especially the financial covenants, which should be used as tools by both parties to manage and police the changing business risks arising between them during the relationship; and
3. events (of default), which trigger an early termination of the relationship, whether such events are "events of default" (in the case of term loan capital) or an "on demand notice" (in the case of on demand loan capital, e.g. a bank overdraft).
Types of financial covenants
Each borrower may require a different suite of financial covenants to suit its and the lender’s particular needs. There are many examples and variations on the particular covenants that may be used, but the same general principles that lie behind them are common to all borrowers. Typical examples include:
Leverage Ratios
• Long Term Debt/Long Term Debt + Book Value of Equity
• Long Term Debt/Long Term Debt + Market Value of Equity
• Total Assets/Total Debt.
Interest Cover Ratios
• EBIT/Interest
• EBITDA/Interest.
Loan to Value Ratios
• Loan Amount/Market Value of (the specified) Asset(s).
Interest Cover Ratios
• EBIT/Dividends
• EBITDA/Dividends.
Current Ratios
• Current Assets/Current Liabilities
• Cash + Receivables + Short-Term Investments/Current Liabilities.
Free Cashflow Ratios
• Operating Cashflow - Capex.
Timely provision of financial information
Not every banking relationship will require a detailed set of financial covenants set out in the facility agreement. However, even where the relative strengths and/or relative size of the lender and the borrower do not warrant financial undertakings more detailed than the timely provision of financial information by the borrower to the lender on request, this does not detract from the business merits of both parties using financial ratios as a non-contractual business tool to monitor the risks and also the overall health of their respective role in the relationship.
Financial covenants are not just for large corporates. The principles behind using them apply equally to small and medium sized businesses. The maintenance of the short- and long-term loan capital of a business is a two-way responsibility. It is clearly the primary responsibility of management to maintain accurate and up-to-date financial information about the business. However, it is also the responsibility of the lender to ensure that management does indeed maintain accurate and up-to-date financial information and, most importantly, make this available on a regular and timely basis to the lender, so that it can analyse how the business is currently doing and where it is likely to go short-term and medium-term.
Different tiers of financial covenants with increasing levels of sanction for breach
As lenders and borrowers enter a new world order of financing, it may be beneficial for lenders and borrowers to focus much more on their mutual interests in developing a strong and long-term relationship. The key to a sound lender/borrower footing is a tight focus on the delivery of accurate and timely financial information, the testing of pre-agreed financial covenants suitable for the particular business and then the effective management of the outcomes from such testing. On that basis, a breach of a financial covenant should not automatically trigger an event of default.
Lenders and borrowers should consider agreeing two or three tiers of financial covenants, with increasing levels of sanction for breach. The first tier covenants would contain easier target numbers to achieve, ratcheting up to tougher numbers for second or third tier covenants. If there were three tiers of covenant, only breach of a third tier covenant would automatically trigger an event of default, whereas breach of a first or second tier covenant would have a lesser sanction, but not trigger an event of default. Alternatively, where there were only two tiers of covenant, only breach of a second tier covenant would automatically trigger an event of default, but breach of a first tier covenant would not.
Considering this in more detail, breach of a first tier covenant might, for example, be used as a tool to give management a sharp reminder that the lender is indeed concerned and that management needs to address those concerns in the next financial period. In order to "incentivise" management not to ignore those concerns, breach of a first tier covenant might trigger an increase in the margin or the payment of an increased commitment fee, if not immediately remedied by a certain date or the next financial covenant testing date. Breach of a second tier financial covenant would be more serious and have a sanction, but not of itself trigger an event of default. Breach might trigger a further increase in the margin or a mandatory prepayment of part of the facility by a certain date (but the trigger for the event of default would be if the required prepayment was not made by the due date). Breach of a second tier financial covenant would act as a warning to management that breach of a third tier covenant might not be far away, in which case management, with the support of its lender, should then be taking more urgent steps to re-organise its sources of capital and the uses of such capital, so as to avoid the relationship reaching a point of no return towards its eventual termination. In fact, this process should sensibly have already started following a first tier covenant breach.
Conclusion
Lenders will, of course, say that the financial covenants are only as good as the financial information provided by their borrowers and that, ultimately, the lenders do not have any control over the quality of such financial information. To a large extent, this is true. However, this does take the analysis of the lender borrower relationship back its origin, which is that lenders should be seeking out relationships with companies with a good business model and, most of all, with strong management teams. With a good business model and strong financial controls in place, a borrower and lender will have the best chance of being a successful team best equipped to manage loan capital over the medium- to long-term.
During this current period of change towards a new financial world order, when lenders will go back to their basic model of lending money again and good due diligence (both before and during the life of a facility) will be at a premium, it is incumbent upon lenders and professional advisers to encourage borrowers to take even more seriously the preparation of good financial information and making this fully available to the providers of their loan capital. Lenders also need to take their share of responsibility by organising their personnel to be able effectively and profitability to review such financial information on a timely basis as and when provided by the borrower. Ultimately, both parties have the same vested interest in the importance of this financial information. Without it, there is less chance of there being a successful relationship between borrower and lender.