Clifford Chance

As different construction sectors take up industrialised construction processes, new commercial and contractual issues are falling under the spotlight. In this first of a series of blog articles looking at the interests of developers, contractors, lenders and other stakeholders in an industrialised/modular context, we consider the point of payment, transfer of title and security.

Payment

Industrialised construction will see a significant portion of project works carried out off-site. This raises the question of when off-site goods/works should be paid for.

Developers and their lenders are likely to prefer a payment model which broadly reflects transfer of value/title and progress at site. Contractors are, contrastingly, likely to favour a regime providing for (often significantly) earlier payment.

Each of these models raises important considerations.

The former would leave contractors bearing the financial burden during the manufacturing stage, which they would likely look to do via external financing. The costs of doing so would likely then be passed back to developers (thus eroding some of the cost saving benefits theoretically inherent in industrialised construction). It would also be likely to trigger increased requests for developer payment security such as guarantees, escrow arrangements or project bank accounts.

The latter, meanwhile, would expose developers to greater risk of non-performance, non-delivery or contractor insolvency. That in turn could see increased contingency financing costs for developers and/or requests for increased contractor performance bonding and insurance solutions.

In the short term, each of these options seems to indicate an advantage for bigger and better capitalised contractors who can either manage the financing requirements or have the covenant and capacity to deliver the increased security. However, in the longer term, it has to be hoped that industrialised off-site processes will help our industry improve its performance record, defuse some of the trust issues that can infect projects and, ultimately, reduce the size and costs of bonds and guarantees.

Accordingly, if developers wish to benefit from being early adopters of modular construction, they may need to become more flexible in their approach to payment structures.

Title and Vesting

At common law, title to goods ('modules' for present purposes) passes on incorporation into works/property, rather than at the point of payment. As discussed above, in an industrialised construction context, this default position may significantly increase the exposure of developers (and their funders) to contractor insolvency.

In practice, many contracts expressly provide for title to pass earlier than the default position, on the earlier of payment or delivery to site. That is one tool the industry has already developed to manage risk in a scenario where payment is required for offsite goods. Others include:

• an appropriately structured stage or milestone payment regime – this would require a significant shift in those construction sectors where practice is for payment to be based on monthly valuations rather than milestones;
• broad inspection and testing rights for developers throughout the manufacturing stage;
• prescriptive 'vesting' provisions, including a requirement that goods are clearly marked as the property of the developer, segregated from the contractor's own property, and insured in the name of the developer (with appropriate funder rights accommodated); and
• warranties that sub-contractors do not retain any title to the relevant goods (and/or, in relevant jurisdictions, a waiver of liens).

The above are likely to be key requirements for developers' funders and they can provide some assurances as to the ability to assert ownership rights in the event of contractor insolvency. However, these devices are not infallible and difficulties may be encountered in establishing or enforcing ownership rights where goods are unidentified, stored elsewhere or where a different local law is applicable (e.g. in insolvency situations in cross-border transactions).

It is worth remembering that in termination or insolvency situations, the ability to enforce ownership rights over offsite 'goods' may only be of limited benefit in any case – the bigger question is whether the developer will be able to complete the work at all without the contractor and/or its offsite manufacturing facilities, particularly if the modular/industrialised product is highly bespoke.

Security

In light of the above, third party security comes back into the spotlight.

Typically, security for advance/offsite payments would come in the form of bank-issued 'on demand' instruments.

The ability of contractors to procure securities for the comparatively greater sums allocated to off-site goods will be influenced not only by their individual bonding capacity but also by the broader appetite of the bond market, as we have noted in previous blog articles.

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Is the answer a move away from on-demand bonding towards higher surety bonding (possibly with allied rights for the surety to step in and complete the project in a default scenario)? Or is the answer that developers and their lenders are simply going to have to factor in sharing a higher degree of risk on contractor non-performance as sectors transition to greater off-site construction? We would be interested in your views…