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Marc Hanson is a partner and William Chung a managing associate at law firm Mishcon De Reya
As businesses get to grips with the implications of the newest form of innovation in the shape of artificial intelligence, one technological advancement that does not seem to have delivered on its initial promise is modular construction.
“Developers need to understand and pre-empt their funder’s concerns over modular construction”
Recent negative headlines following the closure of dangerous modular schools and concerns raised by the National Fire Chiefs Council and the Association of British Insurers over the fire safety of modular buildings have dented confidence in modular construction. It is, however, the financial difficulties of some modular contractors that has had the greatest impact in deterring developers and funders from pursuing modular projects.
Losing confidence
It was only in 2016 that modular construction was heralded as one of the solutions to the Farmer Review’s stark diagnosis of the industry’s need to “modernise or die”. But in the past 18 months, the UK has seen several high-profile offsite construction specialists cease trading. Caledonian Modular and Urban Splash House each fell into administration in 2022. Ilke Homes, meanwhile, was the latest UK modular housebuilder to fall by the wayside when it collapsed in June this year .
In addition, the announcement in May by Legal & General, arguably the patient capital of modular construction, that it was stopping production at its modular housing factory near Leeds, was seen as a lack of confidence in the sector.
So what can be done to revive developer and funder financial confidence in modular construction?
Modular construction undoubtedly carries inherent risks and challenges – the most obvious being the implications of main contractor insolvency before a project is completed when the majority of the project has been prefabricated offsite. The consequences of this “doomsday” scenario need to be sufficiently mitigated by developers legally and contractually at the outset to make modular construction a palatable option for funders and investors.
The valuation process prescribed under the construction contract should as a minimum require delivery of vesting certificates to evidence transfer and ownership of title to the developer once any modular elements that are produced and stored offsite have been paid for.
However, matters get more complex when a modular contractor’s cashflow concerns are factored in, such as their need for frontloaded payment to buy goods and materials and start prefabrication in the factory.
Advance payment or offsite-materials bonds will likely be prohibitively expensive or simply unobtainable given the current limits on contractors’ bonding capacity.
There is no ready-made solution, but creative approaches to explore at project inception include an enhanced retention regime where a percentage of sums applied for in respect of goods and materials is withheld until agreed milestones are met, such as passing an inspection of the fully assembled modules at the factory or delivery of the modules to the site. Additional preconditions to the valuation procedure, such as “not to exceed” figures in an approved cashflow forecast (of which the funder’s monitoring surveyor will have oversight) are also worth considering.
The developer’s right to periodically inspect modules in the factory at key stages of the prefabrication process needs including in the contract to avoid any defects found in delivered modules being repeated in modules yet to be fabricated and delivered to site. If an enhanced retention regime is adopted, the release of any additionally withheld sums should be triggered by the contractor’s successful compliance with any required testing, commissioning and installation requirements demonstrated in the inspection process.
The contract should ensure that, once paid for, goods and materials and the subsequently assembled modules are stored in a location controlled by the developer, or failing that, are set aside and clearly marked as the developer’s property. In an insolvency scenario, this should help the developer to reclaim goods that it legally owns. Once the prefabricated modules are ready for delivery, contractual provisions need to outline obligations around insuring the modules against loss and damage during the loading, unloading and transportation of the modules from the factory to the site.
Copyright issues need to be dealt with in a more nuanced way in modular construction. A modular contractor understandably wants to retain pre-existing intellectual property (IP) rights in stock design given the upfront investment and research and development incurred when creating the design and software to develop its own prefabrication process.
However, the developer’s copyright licence to use the modular items will need to survive termination of the contract (if the modular contractor becomes insolvent) and encompass any project-specific IP developed from the modular process so that the developer can use these for all purposes in connection with that project and that property/site. Failure to provide for this could leave a developer with a building that any potential replacement contractor is unwilling or unable to complete.
Reassuring the investors
Developers need to understand and pre-empt their funders’ concerns over modular construction and ensure these are addressed in the underlying contract. While contractors’ reliance on a sustained pipeline of business to translate their significant start-up costs into profit cannot be ignored, it is important they appreciate funders’ low appetite for a mutual risk-sharing approach, especially given the significant sums needed to purchase modular items that may sit in a factory for some time before being put together on site. This is more pronounced where institutional investment is involved, which brings with it an even higher degree of financial scrutiny and accountability.
A healthy balance needs to be struck to make modular construction a long-term success. Developers need to demonstrate to their funders that insolvency risks have been properly identified and de-risked as far as is contractually possible.
Funders need to focus less on that doomsday scenario and instead embrace the undeniable benefits that adopting modular construction can bring in terms of potential savings in time and cost and the positive impact on sustainability and the environment.
Given the ongoing economic challenges presented by rising material and labour costs and struggling supply chains, carefully considered modular construction procurement can still offer tangible benefits to contractors, developers and their funders.
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