Practical Law

For some years now modular construction has been on the increase for new buildings, particularly in the hotel sector where it is now the norm for new hotels to be supplied with bathrooms and bedrooms manufactured off site. Indeed, I suspect that most of us have stayed in such rooms without even realising that more or less everything in the room (except the loose furniture) was installed off site, and sometimes many thousands of miles off-site.

It may be because I only see the projects where things have gone awry and disputes have arisen, but, having decided a few disputes regarding modular building products, it’s clear that this part of the industry remains susceptible to the types of disputes we see with more traditional methods of construction.

I want to talk about one such case this week, namely the Court of Appeal’s decision in Bennett (Construction) Ltd v CIMC MBS Ltd (formerly Verbus Systems Ltd) (which it handed-down at the end of August). 

Bennett v Verbus – the facts

Bennett was the main contractor for the construction of a new hotel in Woolwich, London. The developer was Key Homes and the hotel operator was to be Park Inn. Bennett entered into a contract with Verbus to design, supply and install 78 prefabricated modular bedroom units for the hotel. The units were to be manufactured by Verbus in China, and the relevant payment terms were in the form of milestones as follows:

• 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.

Disputes arose between the parties at an early stage as to whether the prototype and 78 units produced by Verbus complied with the contract, with Bennett alleging numerous defects. Consequently, milestones 2 and 3 were not signed-off, but Verbus shipped some of the units to the UK at its own risk. In the end, the whole contract came to an end following Key Homes going into liquidation, and the units have since been scrapped.

The adjudication and first instance decision

An adjudication concerning the validity of the milestone payments was decided in Bennett’s favour, but Verbus decided to escalate matters to the TCC by means of a Part 8 claim.

Verbus complained that milestone’s 2, 3 and 4 did not comply with the provisions of the Construction Act 1996 due to issues arising out of the requirement for “sign-off”. At first instance, the judge agreed with Verbus in respect of milestones 2 and 3, but not 4. However, due to workability issues the judge decided that milestones 2 to 5 should be replaced by the payment provisions of paragraphs 2, 4 and 5 of Part II of the Scheme for Construction Contracts 1998 (Part I deals with adjudication).

This meant that Verbus was entitled to interim payments by reference to the value of the work it had undertaken, and it was irrelevant whether the units had reached a stage of completion at which they could have been signed off.

The appeal

The Court had to consider two issues:

• Whether a regime requiring payment of a percentage of the contract sum on “sign-off” of a particular stage of the works complied with the Construction Act 1996.
• If the regime did not comply, the mechanism by which the Scheme for Construction Contracts 1998 was to be incorporated into the contract in order to “save” the bargain the parties had made.

Coulson LJ gave the leading judgment in the appeal.

Issue 1 – did the payment regime comply with the Act?

I won’t dwell on issue 1 as it turns on the facts, and I think issue 2 is of more interest. However, issue 1 does provide some important background.

Verbus acknowledged that milestones 1 to 5 complied with section 109 of the Construction Act 1996, but argued that, in respect of milestones 2 and 3, there was no adequate mechanism for determining what payments became due and when in accordance with section 110(1)(a). Verbus contended (and the judge agreed at first instance) that the sign-off requirement envisaged an actual physical sign-off of the works, and that payment could be circumvented by a deliberate decision not to sign off or prevent others from signing-off.

Bennett submitted that “sign-off” simply meant the date on which completion of the identified stage of the work was achieved and, as such, milestones 2 and 3 complied with the Construction Act 1996.

Coulson LJ noted that the judge at first instance had concluded that the payment provisions offended section 110(1)(a) because Verbus would only have been entitled to payment of milestones 2 and 3 when the units were actually signed-off, thereby adopting a subjective interpretation. The judge also suggested that the criterion to be applied to the sign-off was uncertain and vague due to the involvement of third parties, and that no dates for payment were expressed in the contract.

Coulson LJ rejected all of these points:

• As a matter of construction, he said sign-off was to be assessed objectively, not subjectively, such that the milestones would be paid on the completion of the relevant stage. He noted that there was no reference to actual sign-off being required, or any condition precedent to that effect, and that as such no actual sign-off was required. He also said that, even if actual sign-off was required, a failure to sign-off the relevant documents would not be a defence to Verbus’s claim to payment if the prototype or units were in a state in which they were capable of being signed-off.
• The involvement of third parties was irrelevant because the only relevant criterion was compliance with the contract specification.
• The fact that there was no express date for payment did not matter. The sum became payable when completion of the relevant milestone was achieved.

Therefore, he concluded that the contract contained an adequate mechanism for determining what payments became due under the contract and when, and allowed the first ground of appeal. However, because of its wider importance, he also considered it appropriate to go on and address the second ground.

Issue 2 – what payment mechanism should replace it?

Verbus argued that paragraphs 2 to 4 of Part II of the Scheme for Construction Contracts 1998 should replace the contract’s milestone mechanism in full due to the difficulties of mixing and matching the interim valuation process in paragraph 2 with the original percentages, such that the entire payment arrangement should be based on interim valuations.

Bennett submitted that paragraph 2 was not relevant because there was no agreement as to interim payments, which is the focus of that paragraph. Rather, Bennett argued that the most apposite provision was paragraph 7, which would mean that an entitlement to payment arose seven days after the completion of the work to which the payment related.

Coulson LJ considered the relevant authorities regarding the extent to which the Scheme should be implied, and concluded that:

“I regard it as settled law that, where payment provisions do not comply with s.109 or s.110 of the Act, Part II of the Scheme applies, but only to the extent that such implication is necessary to achieve what is required by the Act.”

He then went on to consider how the court should go about implying the necessary parts of Part II of the Scheme, and noted that there is very little authority on this point. However, he ultimately concluded that in this case it was possible to determine what should be implied in order to achieve a common sense result that “does no significant violence to the parties’ original agreement”.

I would urge anyone trying to grapple with how to imply parts of Part II of the Scheme to read paragraphs 57 to 67 of the judgment, as they provide some helpful guidance on how to navigate these tricky waters. However, in a nutshell Coulson LJ concluded that:

• Paragraphs 1 and 2 of Part II are intended to deal with the problem at section 109 of the Construction Act 1996, namely where there is no provision for payment of instalments or stage or periodic payments. These paragraphs were therefore irrelevant to this case.
• Paragraphs 3 onwards address the problem at section 110, which arises in this case, namely where the parties have failed to provide an adequate mechanism for determining either what payments become due under the contract or when they become due for payment.
• Coulson LJ said that paragraphs 3 onwards deal with four different kinds of payment:

“Paragraph 4 identifies ‘payments of a kind mentioned in paragraph 2’. Paragraph 5 is concerned with final payments. Paragraph 6 is concerned with excepted contracts, and paragraph 7 with ‘other payments’.”

• For obvious reasons Coulson LJ said that paragraphs 5 and 6 weren’t relevant, but he also said that nor was paragraph 4. At first this struck me as odd because paragraph 4 cross references paragraph 2, which expressly refers to payments by “instalments or stage or periodic payments”, and this case clearly concerns stage payments. However, Coulson LJ explained that milestones 2 and 3 are not “payments of a kind mentioned” in paragraph 2 because that paragraph refers to payments based on the value of work performed, and not completion of particular stages as in this case.

Coulson LJ therefore concluded that, by a process of elimination, the catch-all provision at paragraph 7 is the only paragraph that could relate to milestones 2 and 3, such that payment would become due seven days after completion of these milestones.  He also considered that this made commercial sense.

As the timetable for payment was to be implied under paragraph 7, it followed that the interim payment regime under paragraphs 2 to 4 was irrelevant, and the stage payment regime would be maintained.

Take-aways

In my experience, contracts in the construction industry are most commonly based on interim payments for the value of the work completed, rather than stage payments.

This case is a salutary lesson that, where stage payments are to be used, it is very important to properly define the exact requirements of each stage in order to avoid disputes. I recall being involved in a case some years ago where one such stage for payment was when the building was “weathertight”, and much time and money were spent arguing about the meaning of this term.

I sympathise with those involved in this case in trying to determine what elements of Part II of the Scheme were to be implied and, as Coulson LJ says, this part is “badly drafted”. However, it is quite clear that, when considering the extent of this Part to be implied, the courts will place importance on the parties’ original agreement, and imply terms that do the “least violence” to that agreement. This was summed-up in paragraph 67 of the judgment where Coulson LJ stated:

“That links to a wider point about the underlying purpose of the Act. As previously noted, in relation to payment provisions, the purpose of the Act was to provide for certain minimum, mandatory standards so as to achieve certainty and regular cash flow. Save in perhaps exceptional circumstances, it 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. It seems to me that that could only happen where the regime which had been agreed was so deficient that wholesale replacement was the only viable option. That is plainly not this case.”

Some might argue that a single mandatory payment regime would overcome the types of uncertainties encountered in this case and reduce disputes, but do we really need to further erode the rights of parties to freely contract on their own terms?