Financing issues with modular construction

Introduction

The two previous articles in this series have focused on the property and construction issues associated with modular construction.

This article is going to discuss issues which financiers will want dealt with before funding developers in relation to projects incorporating modular construction. This article does not address issues associated with overseas construction.

Summary

In addition to the usual issues financiers are confronted with in relation to any funding (ie sponsor risk, debt servicing, available realisable security of sufficient value etc), financiers looking to fund projects involving modular construction will need to be comfortable with three key risks:

  • Title risk.

  • Competing Personal Property Securities Act 2009 (Cth) (PPSA) security interests.

  • Completion risk.

Developers should be considering the same risks. There are obviously many other issues to be considered, such as insurance risk, transport/delivery, installation etc, but these three provide unique challenges for developers and financiers alike.

Title risk

The starting position for standard building projects is that title to improvements constructed on the developer’s land automatically passes to the developer as they are constructed. Significantly for both developer and financier, the starting position for modular construction projects is that title to (and possession of) modular units will remain with the builder.

The modular construction contract therefore needs to more fairly and carefully establish when title to the modular units passes. The general principle should be that title passes to a modular unit, and its component parts, as and when required progress payments are made by the developer with respect to its construction.

Whilst this may appear straightforward, practical complications can easily arise, especially where there are multiple units being constructed and paid for. It will be important in those cases for inventory to be accurately identified and cross-referenced to payments made. As the modular units will generally remain in the builder’s possession until they are completed, the contract should provide the developer (and financier) with sufficient access to inspect the units prior to making payment, as well as to take possession and control of the units if the builder defaults or becomes insolvent.

Competing PPSA security interests – what’s the worst that could happen?

Having addressed the issue of title risk, it is important that both the developer and financier ensure that title and the financier’s security interest in the modular units have appropriate priority over other potential interests. Merely holding legal title or security over that title will not ensure priority.

As mentioned earlier, in the case of standard building projects, the developer will generally get title to improvements as they are constructed on the developer’s land. As a result, financiers will get effective security over those improvements by means of the priority afforded under the Torrens system of registration. Once the improvements become fixtures, they form part of the land subject to registered title and associated encumbrances and they also cease to be property regulated by the PPSA.

In the case of modular units that have not yet been delivered and installed on the developer’s land, the developer’s and the financier’s interest in those units needs to be protected under the PPSA.

So, what’s the worst that can happen if an interest is not appropriately protected by registration under the PPSA? The answer to this question is perhaps best given with a real example where the application of personal property securities legislation resulted in a surprising and unintended (at least by the owner) transfer of title.

In the case of Graham v Portacom New Zealand Ltd, Portacom leased five transportable buildings to NDG. NDG granted a debenture over NDG’s assets to HSBC and HSBC registered the debenture under New Zealand’s Personal Property Securities Act 1999 (NZ-PPSA). HSBC appointed receivers over NDG’s assets and the receivers claimed a right to sell the transportable buildings. Portacom argued that NDG had only a possessory interest and therefore HSBC did not have a right to sell the buildings. The High Court of New Zealand held that a lessee (NDG) had both possessory and proprietary rights in leased goods under the NZ-PPSA such that a secured creditor of the lessee (HSBC) could acquire rights in priority to those of the lessor (Portacom). Therefore, the effect of the NZ-PPSA in that case was that NDG was able to transfer to HSBC a better title in the transportables than NDG possessed (ie the right to sell them).

The key lesson from the Portacom case is that parties with properly protected security interests can defeat other interested parties, including those with legal title to the particular assets.

Application of the PPSA, as it applies to modular units, may result in a number of potential parties with competing security interests.

They can include:

The builder

The builder may, at various stages of construction, have a security interest in, and legal title to, modular units and component parts.

It is therefore critical that the developer’s rights in relation to the modular units being constructed for it are properly documented so as to create a security interest registrable under the PPSA, which is then adequately protected by PPSA notifications.

One of the key messages from the PPSA is that a party’s title to property can be affected if it allows another party to have possession or control of the property. A key risk for the developer in the case of modular construction will arise once title in the modular units passes to it but the builder still has possession.

Suppliers to the builder

A supplier’s interest in goods supplied on credit (to the builder) can be registered on the Personal Property Securities Register (PPSR) as a Purchased Money Security Interest (PMSI). A conditional sale agreement (ie retention of title arrangement) will also create an interest in the supplier capable of being registered on the PPSR.

It should not be assumed that once a supplier’s goods become part of the modular unit that the supplier’s security interest is lost. Under the PPSA, a security interest in goods that subsequently become part of, or attached to, the modular unit can continue as a security interest even if those goods are no longer readily identifiable.

Other third party security interests over either the developer’s or builder’s assets.

The financier should be alert to any other competing security interests, for example, all assets charges (GSAs) affecting either the developer or the builder.

Great care (and advice) is therefore required on the part of both the developer and the developer’s financier to ensure their respective positions are protected. A thorough search of the PPSR is required in relation to both the developer and the builder. In addition, the necessity for accurate identification of the modular units and their component parts cannot be overemphasised.

As a minimum, the financier should insist on releases of any competing security interests over the developer before funds are advanced.

In relation to the builder, the financier should also require that any security interests in the modular units or component parts of the units are appropriately released as and when payments are made to the builder. As part of this, the developer and the financier will need to ensure that any suppliers with security interests in component parts that have or will become a part of the modular units are paid as part of progress payments being made by the developer and the developer’s financier.

Completion risk – how does the financier (and the developer) ensure the modular units are available?

As with any construction project, the financier will want to ensure the integrity of the building contract is not prejudiced. An integral part of this will be a side deed whereby the financier obtains direct contractual comfort from the builder. This comfort should contain provisions, some of them standard for all construction projects, ensuring:

  • the financier has control over material variations;

  • enforcement by the financier does not entitle the builder to suspend or terminate;

  • the financier can step in under the building contract and enforce the developer’s contractual position;

  • the financier gets notice of, and rights to cure, defaults; and

  • the financer can obtain access to the builder’s premises to inspect and, where appropriate, take possession of the modular units.

With a modular project, the provisions of the side deed will need to be tailored to ensure any gaps in the developer’s position vis a vis the builder are filled and dealt with, including with respect to unfixed goods, insurance, delivery and installation. As part of this, it will be critical for financiers to obtain adequate legal advice on the quality of the building contract.

Where the builder is operating from leased premises, particular circumstances may warrant a review of the lease held by the builder, at least so the financier is aware of any particular risks and can, as part of this, assess the need for the developer to obtain direct comfort from the landlord regarding access to the premises.