With high profile investment in the sector by the likes of Legal & General and Laing O’Rourke, and endorsement as part of the Farmer Review of the UK construction labour model, off-site manufacture is taking a prominent place in discussions about the future of the construction industry.
While off-site manufacture has never really hit the mainstream (partly due to the capital outlay required and the risks associated with a cyclical market), there are signs of change in the market, fuelled by labour shortages and the rising costs of traditional construction. Developers need to consider whether existing contractual structures cater for the legal risks associated with this part of the market.
A broad spectrum
Off-site manufacturing, modern methods of construction or pre-fabrication (as it is sometimes known) encompasses a broad range of techniques that reduce the level of on-site labour and focus on off-site or near-site production of materials and components. The physical output can range from entire modular construction to panelised systems, bathroom pods and more. The method selected will influence the procurement structure and the associated legal risks. Like off-site manufacturing itself, there is no one-size-fits-all legal solution.
Current contracts
The majority of construction contracts are drafted with traditional construction practices in mind. They assume that a contractor and its supply chain will carry out the work on site (as well as elements of design) and that the contractor will be paid in arrears for work completed and materials delivered to site.
There is usually an element of flexibility to allow payment for goods and materials stored off-site, which can be extended to cover elements of off-site manufacture. Most contracts are not, however, drafted to cater for the off-site manufacture of significant elements of a building.
Developers need to understand the overall procurement structure in which off-site elements are manufactured and ensure that they are adequately protected.
Ownership
Ownership of items should transfer to the developer when it pays the contractor.
The contractor should show it is able to pass ownership, either by all relevant parties documenting the transfer of ownership through the supply chain in a standalone agreement (vesting certificate); or the contractor providing evidence that ownership has vested in it by a vesting certificate between the contractor and the supplier or by providing the sub-contract document evidencing that it has title which it can pass to the developer.
Risk and insurance
Risk generally passes at the same time as ownership, unless agreed otherwise.
As ownership tends to transfer on payment (to provide greater protection for a developer in an insolvency situation), risk may well pass to the developer when it has no control over the items or the place of storage.
This is usually resolved by the party at whose premises the items are stored, taking the risk of damage or loss occurring and agreeing to insure that risk (as all risk policies do not generally cover items until they are placed on or adjacent to the site).
Storage and access
Items should be stored separately and be clearly and visibly marked by letters, reference or code to identify that they are the developer’s property and have been allocated to a particular project.
Minimising insolvency risks for off-site items
- If payment is being made before items are delivered to site, ownership in those items should be transferred to the developer when payment is made, wherever possible
- All risks insurance will generally not cover items before being delivered on/adjacent to site so additional insurance may be required
- Project managers (or equivalent) should be required to regularly check that items are set aside and tagged as required
Additional considerations for overseas items:
- Are there any insolvency rules and/or local laws that cannot be contracted out of and which may override what the parties have agreed contractually?
- Are vesting certificates (which transfer ownership of goods up the supply chain) enforceable where the items are being stored/ manufactured? If not, what mechanism should be used?
- Is a local agent needed to check that items are stored and labelled as required?
- If things go wrong, are there any additional steps that need to be taken before the items can be moved?
- If items are being transported by ship, how do the shipping documents (bills of lading) affect what the parties have agreed?
This is essential to minimise the risk of them being appropriated by an insolvency practitioner.
It is not enough to rely on the contractor or manufacturer doing this so a developer and its team should have a right to go to the warehouse, inspect storage arrangements and, assuming they have been paid for, remove materials.
Financial protection
Occasionally things go wrong. While a bond cannot compensate for the lost time and programme implications of having to find an alternative manufacturer, it can provide an element of financial protection.
Such bonds are generally on-demand and allow the beneficiary to make a call in the event that the finished items are not delivered when required.
Incomplete items
The position is trickier if an off-site manufacturer seeks payment for incomplete items as it may not be possible to transfer ownership until the items are, at the very least, finished. Trying to obtain security over the constituent parts might seem like a solution. While it is possible, the courts tend to be unwilling to find that ownership in materials passes before they actually become part of the structure of the product/item.
The issue is also complicated if the supplier of the constituent parts will not transfer ownership until it is paid, if the constituent parts are not capable of being uniquely identified and/or have not been allocated to the project.
Legal niceties aside, owning the constituent parts may not help on a practical level if they cannot be used by the replacement manufacturer.
Consideration should be given to whether the sequence of manufacture can be changed so the developer pays for, say, 50 complete units (where ownership can be transferred) rather than towards 100 incomplete units. Can payment arrangements be restructured to reduce the exposure? Can early deposit payments be reduced with further instalments dependent upon some form of physical output?
Insolvency
Insolvency is an ever present risk. As with more traditional construction practices, carrying out thorough due diligence and understanding the supply chain still remains the best way of understanding the risk and deciding how to tackle it. Annual accounts may be out of date, so requesting copies of management accounts and/or carrying out a Dun & Bradstreet report are probably more useful ways of establishing the financial stability of a proposed supply chain member.
Once an off-site manufacturer is chosen, consideration needs to be given to how to protect a developer’s interest. This is particularly important if, as is increasingly the case, a developer pays for items before they are delivered to site or other place under its control.
If the manufacturer or person responsible for storing the items becomes insolvent, the items may be treated by the insolvency practitioner as the manufacturer/storage party’s assets rather than the developer’s. Even if the insolvency practitioner is persuaded that the items are in fact the developer’s, the project may be delayed if items are not released from the warehouse when they should be. At the most extreme, the insolvency practitioner may “deal” with the items leaving the developer to bring a claim for damages for the tort of conversion and an urgent need to find an alternative manufacturer.
These risks can be minimised with clarity about ownership and storage requirements and a robust inspection regime. If the right steps are taken, a developer should be able to recover items even if a supplier/manufacturer becomes insolvent.
As well as considerable benefits, off-site manufacturing brings risks. However, with careful planning and structuring it is possible to mitigate them.
Angus Dawson is a partner in the construction group at Macfarlanes LLP
