Practical Law

Increasingly, our clients are requesting that we incorporate provisions for modular building techniques into their construction contracts. There seems to be a real trend for including at least some aspects of “modular” into development and other projects.

It is open to debate whether this is driven by improvements in design and adaptability of modular building as a construction method, or by market forces such as labour shortages and rising material costs. The fact remains that modular building is on the increase and brings with it some key considerations in terms of risk.

What is modular building?

In short, modular building can take many forms. Off-site manufacturing can range from the more traditional, somewhat negatively viewed flat-pack, pre-fab house, through to fully finished components or pods (for example, bedroom, bathroom, apartment or office) as well as panelised systems and facades.

The broad range of techniques means there is no uniform legal solution. Contracts will need a degree of tailoring, just as the modular method is tailored to the particular project. Understanding the key technical issues involved will help to shape the questions we need to ask when considering contracts for modular projects. From a contracting point of view, it is important to know from the outset how the modular components will function in terms of:

• The off-site design and construction.
• In-transit delivery
• On-site installation and integration.

The balancing process

Off-site prefabrication has never become mainstream. It requires a balance between the repetitive design which enables the necessary economies of scale to be achieved, and an appealing, well designed end product. The disadvantages of modular construction as compared to more traditional methods include not only limited design and aesthetics that are insufficiently user specific, but issues such as:

• Significant investment with one primary contractor to design and manufacture; a potential monopoly which places the contractor in a strong bargaining position and increases risk upon default or insolvency.
• Potential for manufacture of components abroad, with increased transit risk, marine and other insurance issues, jurisdictional risk in terms of enforcement in the event of failure or default, and a less environmentally sustainable footprint than anticipated.
• Lower valuation of the end product based on historic perceptions and performance issues.

Fundamentally, the pros and cons of modular building that need to be balanced against each other are the increased cost of construction against the potentially reduced construction time. These are crucial factors that need to be weighed up carefully. Quite simply, if the project requires increased flexibility in terms of design and the programme permits this, it may well be cheaper to build traditionally.

As the upfront investment in factories that produce components is recouped over time and established pipelines of projects increase, it may be that manufacturing costs will decrease as the necessary economies of scale can be achieved.

Modular construction today

These factors have made modular construction well suited to larger scale projects such as hotel and build to rent schemes that allow rental income to be realised as quickly as possible. Earlier this year, the Mayor of London approved plans for a 21 storey building in Croydon using modular construction and offering 100% affordable housing.

The government’s inquiry into off-site manufacture for construction is currently underway (submissions closed last month), exploring how construction industry productivity can be improved. It will also consider how government public procurement policy may need to change to encourage economically and environmentally sustainable practices potentially facilitated by off-site manufacture. Modular building is clearly on the industry radar.

Preliminaries

Is the modular works contract one for the supply of goods, or both goods and services? An early question to consider is the extent to which the Construction Act 1996 applies. It applies to contracts where construction operations are carried out in England, Wales or Scotland.

Where pre-fabrication work is “local” and the project location is overseas the Construction Act 1996 is unlikely to apply to the prefabrication contract. In Palmers Ltd v ABB Power Construction Limited [1999] BLR 426 it was held that fabrication of plant on one site, before its transport and erection on another site amounted to “construction operations” under the Construction Act 1996 because the plant would “form” part of the land once erected. However, the legislation would not apply if the site on which the plant was installed was outside England, Wales or Scotland.

Where pre-fabrication work is overseas and it is a “local” project location, the Construction Act 1996 may apply to the pre-fabrication contract if it also provides for installation on site (s. 105(2)(d)).

Key risks

Some of the key risks often identified in relation to modular building are quality control and interface with other construction elements. Clearly expressed rights to inspect and test during the off-site design and construction phase, as well as during storage and transit, go some way to addressing these issues, by assisting in early identification of design problems and ensuring that the modules are labelled and set apart in the factory and in transit.

Highly publicised failures that involve modular construction, such as the shocking collapse of the Florida pedestrian bridge in March this year, highlight the need for a more hands on approach by developers and their consultants when compared to traditional construction methods.

Title and passing of risk in components go hand in hand, particularly in the event of default or insolvency on the part of the modular contractor. They are also key issues for funders, as a relatively significant cost of the project is tied up in the modular components well before they arrive on site. Lenders may consider that they are effectively being asked to fund development costs, unlike under a traditional contract model. As a result they may require the modular contractor to enter into a vesting agreement ensuring that ownership passes upon payment.

The advanced funding risk for lenders can be mitigated through on-demand bonds, where possible the expenditure of any equity component first and charges over the components. However, bear in mind that security over components or their constituent parts is only useful where those parts can be used by a replacement modular manufacturer. There are reports of large scale developers and contractors, such as Laing O’Rourke, investing in their own modular construction business in order to alleviate these risks.

Consider also that ownership and risk for items may pass to the developer at a time when it has no control over those items or their place of storage. Additional insurance will be required and an efficient delivery schedule encouraging just-in-time delivery, such that components are not unnecessarily stored unused on site.

However, it is the knock on effect of any one of these issues going awry that is crucial, as the potential for increased cost, disruption and delay may be significantly amplified as compared to traditional construction methods. Depending on the scale of the modular component, both in physical and financial terms, the potential for problems is exacerbated. There are likely to be limited numbers of modular contractors who are able to “step-in” to the project and their production methods may be incompatible. Wholesale or significant redesign will always be costly and time consuming.

Procurement – back to basics?

So how will standard form construction contracts cope? And what is the preferable procurement method? The answer is to keep it simple, while recognising that traditional forms will not adequately reflect the risks and their allocation. A well-managed contract is always key and a contract which is more administratively hands on, rather than turnkey in style, is likely to be well-suited to modular construction, provided it is correctly administered.

While there has been considerable publicity in recent years over the apparently impossibly short time scales and reduced labour costs that modular construction can achieve, these key advantages must be balanced against the potential avalanche should things go wrong. Risks should be managed through both the procurement structure and the contract terms. The avalanche effect can be mitigated by careful planning and a well-structured contract. Choose your modular supplier carefully, finalise design at an early stage and administer the contract well.