Modular construction – making payment terms work

Modular construction has many advantages over more traditional construction methods, including accelerated build times, reduced build costs and improved quality. One topical example is the new hospital planned in Wuhan, China to deal with the outbreak of the Coronavirus. According to media reports, the 1,000 bed hospital is to be constructed using pre-fabricated buildings in just six days.

However, modular construction does require employers and contractors to consider some additional risks, particularly in relation to payment for off-site materials.

Minimising payment risk

In order to manage these payment risks the terms of a modular construction contract should be carefully considered and clearly drafted. The recent decision in Bennett (Construction) Ltd V CIMC MBS Ltd (formerly Verbus Systems) Ltd [2019] EWCA Civ 1515 highlighted issues that can arise in relation to milestone payment provisions. Milestone payments are often incorporated into modular construction contracts to balance the modular supplier’s cash flow requirements with the insolvency risk associated with paying for works which have not been installed on site.

Milestone payments

In this case, Key Homes was the developer of a new Park Inn Hotel in Woolwich, London. Bennett was employed as the main contractor and sub-contracted with CIMC to design, supply and install 78 modular bedroom units, to be manufactured in China.

The contract for the modular units was based on an amended form of JCT Design and Build Subcontract 2011 (Subcontract). The interim payment provisions were deleted in their entirety and the following payment milestones were inserted instead: 

• Milestone 1: 20% deposit payable on execution of the contract.
• Milestone 2: 30% on sign-off of prototype room by Park Inn/Key Homes/Bennett in China.
• Milestone 3: 30% on sign-off of all snagging items by Park Inn/Key Homes/Bennett in China.
• Milestone 4: 10% on sign-off of units in Southampton.
• Milestone 5: 10% on completion of installation and any snagging.

Key Homes went into liquidation and following this the Subcontract came to an end. CIMC then commenced adjudication proceedings against Bennett for non-payment. The dispute between the parties centred on what was meant by “sign-off” in milestones 2-4, as there were no timings prescribed for the sign-off process.

Adequate payment mechanism required

Under the Housing Grants, Construction and Regeneration Act 1996 (Act), a construction contract must contain an ‘adequate mechanism’ for determining what payments become due and when, as well as the final date for payment. If the payment provisions of a construction contract do not provide for these minimum requirements, the relevant provisions set out in the Scheme for Construction Contracts (England and Wales) Regulations 1998, as amended, (Scheme) will be implied into the contract to effectively ‘rectify’ the offending provisions and ensure that an adequate payment mechanism exists.

The Subcontract here was a construction contract for the purposes of the Act. The two key issues were:

(i) did the payment regime in the Subcontract comply with the Act and

(ii) f not, which payment mechanism should replace it?

The adjudicator decided that the milestone provisions were compliant with the Act and therefore enforceable. CIMC then commenced proceedings in the Technology and Construction Court disputing this and contending that the milestone payment regime was non-compliant. 

The Courts’ decisions

The Technology and Construction Court held that milestones 2 and 3 were non-compliant and that milestones 2 -5 should be replaced by the payment regime contained in the Scheme. This decision was further appealed by CIMC.

On appeal it was held that the milestones provided an adequate payment mechanism and were therefore compliant with the Act. The Court of Appeal concluded that “sign off”, which was not defined in the Subcontract, was to be interpreted objectively. The works were “signed off” when they were complete and in a position where they could be signed off, otherwise Bennett could have refused to formally sign off the works and no payment would ever become due. Actual “sign-off” was not required.

The Court also said, in passing, that if the milestone payments had been found to be non-compliant with the Act and therefore there was no adequate payment mechanism in the Subcontract, paragraph 7 of Part II of the Scheme would have applied. The Court of Appeal confirmed that the Scheme can be implied on a “piecemeal” basis insofar as non-compliant payment terms are concerned; only those parts of the payment mechanism in the Scheme are implied into the non-compliant contract as are required to achieve compliance with the Act. If provisions from the Scheme had been implied in this case, payment would have fallen due seven days after the completion of the works to which the payment related.

Preserving agreed payment mechanisms

This case provides a stark reminder of the importance of clear drafting in order to avoid disputes. It also shows that, where possible, the courts seek to preserve payment mechanisms agreed by the parties and will only imply provisions from the Scheme where absolutely necessary. Coulson LJ emphasised that the Act was “not designed to delete a workable payment regime which the parties had agreed, and replace it with an entirely different payment regime based on a radically changed set of parameters”.

The Court also referred to incorporating provisions from the Scheme “in order to ‘save’ the bargain which the parties made.”

Location, location, location

Most UK or ‘local’ construction contracts with modular or off-site elements are likely to be construction contracts for the purposes of the Act. In this case the Subcontract was taken to be a construction contract to which the Act applied. However, it is worthwhile considering the extent to which the Act applies where the project is located, or part of the works are carried out, abroad. In this case, the pre-fabrication of the bedroom units was in China and the project location was England. The Act applies to construction operations carried out in England, Wales and Scotland, not abroad, although where pre-fabrication work is overseas and the project location is ‘local’, as in this case, the Act may apply to the pre-fabrication contract if it also provides for installation on site.

Contract provisions for modular construction

As well as the payment mechanism, other contractual provisions should be considered in order to manage the risks of modular construction. These might include:

• Rights to inspect and test the works during the design, construction and transport phases, to assist with the early identification of problems.
• An efficient delivery schedule to avoid the units being prematurely stored on site.
• The transfer of title, following payment of the units (which have not yet been delivered to site). Additional insurance should also be considered if the ownership and risk of the units is to be passed at a time when there is no control over these items, their place of storage or their transport to site.
• A cap on payment for the off-site materials.
• Liquidated damages for the failure to provide the modular units within a specified time.
• Suitable retention - withholding a percentage of the value of the works until completion or the making good of defects.
• Performance bond, as additional security against insolvency.

Where the Act applies, all the requirements of the legislation, such as provisions in respect of adjudication and payment must be complied with. Milestone or similar payment arrangements can easily be accommodated, but they should be drafted with care and precision. Ensure there is no room for doubt as to when the payment falls due and take care not to breach the prohibition in the Act in respect of conditional payment terms, for example pay-when-certified clauses. Among other things, the Act prohibits making payment conditional on certification under another contract.

As Coulson LJ said in this case, the “precise trigger for payment will depend upon the terms of the contract.”

The payment ‘trigger’ is likely to need more careful consideration where modular or off-site works are involved and other requirements, such as inspection and testing, must be accommodated.

This article was written by Jane Burrows and appears in the Spring edition of our construction, engineering and projects publication, Construct.Law. For more information, please contact Jane on +44 (0)20 7438 2221 or at jane.burrows@crsblaw.com.