Modular construction: addressing deposit payments in building contracts

Introduction

Modular construction has become increasingly popular in recent years. Once synonymous with ‘pre-fab’ houses and concrete tower blocks, the potential cost, programme and quality benefits mean it is now seen as a potential solution to the existing housing crisis, something my colleague Alexander Gold has written about - read more.

Modular construction does, however, give rise to a number of potential legal issues. In this article we will consider one such issue concerning payment protection for the employer.  In the coming weeks we will be writing about other issues such as design liability and collateral warranties.

The problem

Often the modular manufacturer is a sub-contractor/ supplier to the main contractor. This is particularly the case where only specific elements of the building (for example, bathroom pods in a hotel) are constructed off-site as opposed to the entire development. The nature of off-site manufacture means that factory slots need to be reserved, often months in advance and typically a modular manufacturer will require a deposit payment before a slot is reserved. The modular manufacturer will then usually require further payments to be made during the manufacturing process and before the items are ready for delivery to site.

The problem is that such payments are not adequately covered in the payment provisions in standard form building contracts. These tend to assume that ‘traditional’ construction methods are used and therefore the contractor’s right to payment for materials usually arises when those materials are delivered to site.

There may be exceptions to this where payment can be made prior to delivery if certain conditions are met. These conditions often include the relevant items being identified in the building contract, proof that ownership in the item has vested in the contractor being provided, that it is insured and that it is set aside and labelled at the off-site premises.

The problem here is that these conditions cannot be satisfied where an item is yet to be manufactured or is in the process of being manufactured. Therefore, the contractor has no right to recover these payment from the employer unless it has a specific entitlement to an advance payment under the building contract.

Possible Solutions

The contractor could use its own cash reserves to fund the payments to the modular manufacturer. However, if the project requires a substantial amount of modular manufacturing this is unlikely to be acceptable to a contractor as it could have a significant impact on their cash flow.

The alternative is to amend the payment provisions so that the employer makes payments for the modular manufacturing before the relevant items are delivered to site. However, this potentially means the employer would take the risk of the contractor becoming insolvent before the items are finished and delivered to site.

Advance Payment Bond

Perhaps the safest option for the employer is to have any upfront payment secured by an on-demand bond. Advance payments can be made to cover the payments required by the modular manufacturer. The advance payment is re-paid by deductions from subsequent payments due to the contractor.  For example, the payments that would be due when the off-site items are delivered to site. The monies would be secured by a bond so that the employer can recover its advance payment in the event that the contractor becomes insolvent before the entire sum has been repaid.

The main drawback is one of cost. Depending on the extent of the advance payment required, a bond may be prohibitively expensive. For the employer to be properly protected an advance payment bond needs to be on-demand in nature. The distinction between on-demand and performance bonds merits an article in its own right but for present purposes it is sufficient to note that, in the event that the contractor becomes insolvent, the employer could not recover the advance payment under a performance bond until the works had been completed and its overall losses ascertained. On-demand bonds tend to be expensive (and, in some cases, contractors are simply unable to provide them) but they should allow an immediate pay out if the contractor becomes insolvent with any advance payment outstanding.   

The other drawback from the contractor’s perspective is that if they provided an advance payment bond to the employer without getting a back to back bond from the modular manufacturer, they would be taking the risk of the modular manufacturer’s insolvency. They would have to source an alternative modular manufacturer without being entitled to further payment from the employer.

Step-in provisions

A more cost-effective solution could be to include a contractual mechanism to allow the employer to step in to the contractor’s agreement with the modular manufacturer in the event the contractor becomes insolvent. The easiest way to achieve this would be to include step-in provisions in a collateral warranty between the modular manufacturer and the employer. Such provisions would stipulate that, in the event the contractor becomes insolvent, the employer would have the option of ‘stepping in’ to the contractor’s position under its agreement with the modular manufacturer.

The risk for the employer is that, when stepping in, he takes on all existing liabilities of the contractor to the modular manufacturer. If, despite the employer paying the contactor for sums due to the modular sub-contractor, this has not been passed on to the modular manufacturer, the employer would effectively have to pay twice. That said, this risk could be mitigated by having robust payment provisions in the main contract where the contractor would need to provide proof of payment to the supplier before being entitled to payment from the employer.

Vesting certificates

Advance payment bonds and step-in rights are primarily designed to manage the risk of the main contractor becoming insolvent. However, what about the risk that the modular manufacturer becomes insolvent? This is primarily the risk of the main contractor who would remain under a contractual obligation to the employer to deliver the modular elements of the project notwithstanding the insolvency of the modular manufacturer.

Ideally, and as with an employer, the main contractor would obtain an advance payment bond from the modular manufacturer to mitigate this risk where up-front payments are required. However, the main contractor (and the employer) might also consider obtaining vesting certificates over off-site components or their constituent parts. Vesting certificates can make clear that ownership has passed, that the offsite items are adequately insured, are set apart and identifiable as the property of the main contractor or employer. Importantly they give the main contractor or employer a right to access the modular manufacturer’s premises to retrieve these items should the modular manufacturer become insolvent or not deliver the items to site as required.

Vesting certificates are only possible if there is something that has been manufactured that can then “vest” in the main contractor and/or the employer. Further, they are only useful where those parts could be used by a replacement modular manufacturer. In that sense, they are only an effective form of protection from the point when useable components have been manufactured.  

Conclusion

Ultimately, the solution to this issue will depend on the circumstances of the parties and the amount of the payments required before the relevant items are delivered to site. In some cases an employer may be willing to take on the risk of contractor insolvency and make the payments. In other circumstances, the value of those payments and the wider project is such that an advance payment bond is justified.  What parties should ensure in any project involving modular construction is that the payments required by the modular manufacturer are discussed at tender stage and an appropriate payment arrangement agreed. The last thing either party wants is to get to a point where a factory slot needs to be reserved in order to keep to the programme but with no agreement as to who is responsible for taking the risk of that payment. 

This article was written by Christopher Busaileh. For more information, please contact Christopher on +44 (0)20 7427 4546 or at christopher.busaileh@crsblaw.com your usual Charles Russell Speechlys contact.