Black holes and construction disputes: new cause for concern? 

United Kingdom

A recent TCC decision has determined that the principle of “transferred loss” developed to overcome legal “black holes” will not apply where parties have included wording in their contract disclaiming any intention to confer rights on third parties. Such wording is commonly included as boilerplate language in UK construction contracts and appears in the JCT and NEC forms of contract. The court’s decision means that the transferred loss principle is unlikely to be available to plug any black holes arising in connection with such contracts, increasing the importance of structuring projects to avoid the creation of black holes.

What is a legal “black hole” and how do they arise on construction projects?

In a construction context, a legal “black hole” is said to arise where a construction party is unable to be pursued in relation to breaches of contract (usually defects) because the building in question is owned by a different entity to the employer under the relevant construction contract. Historically, they were often alleged to arise where a defective building had been sold to a third party for full market value with an assignment of rights under the building contract following later upon discovery of the defects by the purchaser. It was said that the assignee purchaser could not claim against the contractor for the defects because the original employer had received full market value and had therefore suffered no loss (the assignee being limited to the amount claimable by the assignor). Specific principles have been developed by the courts to overcome these arguments and the test is simply whether the original employer-assignor could have claimed against the contractor had it not assigned its rights and not sold the building.

A second type of black hole may arise where, as is common in development projects, the employer is a separate entity from the owner of the land on which the development is to be built. In a number of cases involving defective work it was argued that the employer in such circumstances had suffered no loss as it did not own the works in question and had no obligation to have them repaired. In response to these difficulties, a principle known as “transferred loss” emerged.

The principle of “transferred loss” is complex and not yet fully settled in law, but is usually divided into a “narrow ground” and a “broad ground”. The narrow ground builds on carriage of goods cases and provides that the employer may claim on behalf of a third party purchaser where such purchases are foreseeable at the time of the building contract. The broad ground applies simply where one party to a contract agrees to confer a benefit on a third party. Provided it can be shown that there was a common intention and a known object to benefit the third party, the third party’s loss may be recovered by the other party to the contract.

The narrow ground is useful for avoiding black holes in purchaser situations where assignments are not possible; for example, where the building contract contains a prohibition on assignment. The broader ground is useful for avoiding black holes where the employer and owner are separate entities as noted above. Both grounds are susceptible to any contrary indications in the contractual arrangements. In one case, the fact that the owner had been given certain restricted rights against the contractor under a duty of care deed was sufficient to prevent the broad ground from applying.

How are they usually avoided?

Typically employers and interested third parties will seek to put in place contractual mechanisms to avoid needing to rely on the transferred loss principle in order to seek recourse against culpable construction parties. This can be achieved either through procuring collateral warranties or third party rights from the construction parties to interested third parties, or through assigning the benefit of the original construction contracts to a relevant interested third party. However the provision of direct contractual rights through a collateral warranty or third party rights will not always be sufficient to avoid issues arising where the original employer entity has not suffered any loss as a result of the breach complained of, or has suffered a loss which is different to that of the beneficiary of the warranty/third party rights.

An issue arises where the warranty/third party rights contain a clause which provides that the construction party shall owe no greater liability to the beneficiary under the warranty/third party rights than it owed to the employer pursuant to the underlying construction contract. Such clauses are commonly used to ensure any limitations on liability in the underlying contract will also apply to claims under the warranty/third party rights, but they can operate to defeat or reduce claims by beneficiaries  where the employer has not suffered a loss as a result of the breach complained of, or where the employer has not suffered the type of loss which the beneficiary is seeking recover, because in such circumstances the construction party would not be liable to the original employer for the relevant loss  To avoid this issue it is important to ensure that the no greater liability provision is drafted on terms which ensure that this type of “no loss” defence cannot arise. That can be achieved by either providing that the construction party will have no greater liability to the beneficiary than it would have had if the beneficiary had been “joint” employer under the relevant underlying contract, or by expressly excluding the application of a no loss defence.

On projects where the employer under the construction contracts is not the owner of the property, the risk of no loss arguments can be mitigated by ensuring that the employer owes appropriate development obligations to the owner and other interested third parties. However, this can be difficult to achieve in practice, as if works are being procured through a development manager or management contractor such parties will often only accept limited or qualified development obligations. Consequently, it is best practice to ensure that the rights granted to third party beneficiaries are on terms which avoid no loss arguments arising, regardless of the nature of development obligations owed elsewhere on the project.

Dr Jones Yeovil Ltd v The Stepping Stone Group Ltd

Stepping Stone contracted Dr Jones Yeovil Ltd (“DRJ”) to build and refurbish a total of 11 assisted living units for elderly residents. The work was let under three separate contracts on amended JCT Design and Build 2005 and JCT Minor Works 2011 terms. The property on which the works were to be carried out was owned by a subsidiary of Stepping Stone (“NCL”). Once complete, NCL disposed of the units on long leases whilst retaining a freehold interest in the common parts.

After completion of the works, a dispute arose between Stepping Stone and DRJ as to the defective work, including in relation to the heat pumps installed in the units.  The Employer’s Requirements had specified Ground Source Heat Pumps, whereas other heat pumps been installed which were less efficient. Stepping Stone claimed for the increased electricity usage arising from the less efficient pumps.

Among a number of points made in defence of this claim, DRJ claimed that Stepping Stone itself had not suffered any increased electricity usage, as it was neither owner nor occupier of the units. The increased electricity usage was suffered by the leaseholders who had purchased the units from NCL.

In response, Stepping Stone sought to first to rely on the existence of a development agreement between it and NCL obliging it to indemnify NCL in relation to defective work. However, there was no written evidence to support such an agreement and it was rejected by the court. Stepping Stone therefore relied on the broad ground of the principle of transferred loss, arguing that the development was ultimately for the benefit of those leaseholders who had purchased the units from NCL. 

Black hole upheld

The court upheld DRJ’s defence on this issue, finding that Stepping Stone was unable to claim in respect of the increased electricity charges suffered by the leaseholders. Of decisive importance was the fact that the construction contracts retained the standard JCT wording that “nothing in this Contract confers or is intended to confer any right to enforce any of its terms on any person who is not a party to it.” (clause 1.5 and 1.6 of the Minor Works and D&B form respectively). Excepted from this wording were any third party rights or collateral warranties specified in the contract in favour of purchasers, tenants or funders. However, no such rights had been specified pursuant to what Stepping Stone had said to be housing association practice not to leave leaseholders to bring their own claims against the contractor.

In the court’s judgment, these standard provisions made it impossible to conclude that the construction contracts had the known object of benefiting the leaseholders and accordingly the transferred loss principle could not apply:

“Clauses 1.6 and 1.5 respectively were express contractual provisions amounting to a positive disclaimer of the suggested third party benefit.  … the principle of transferred loss is an exception to the law of obligations.  When the parties to the contract have specifically addressed the lack of third party entitlement, and curtailed obligations accordingly, I can see no proper basis for overriding their agreement.

Conclusions and implications

Since the enactment of the Contracts (Rights of Third Parties) Act 1999, clauses disclaiming any intention to benefit third parties have become commonplace in the UK. The NEC form of contract contains similar provisions to the standard JCT terms noted above (in optional clause Y(UK)3). The court’s finding that such boilerplate provisions will prevent the principle of transferred loss from applying is therefore significant. As the present case shows, this principle remains relevant where the usual methods of avoiding black holes have not been implemented for whatever reason. The potential exclusion of the principle makes it more important than ever that the usual precautions are put in place. Parties should therefore give careful thought to the contractual structures agreed for a given project or development and ensure that black holes are avoided through the use of appropriately worded development agreements, third party rights and/or collateral warranties.

References:

Dr Jones Yeovil Ltd v The Stepping Stone Group Ltd [2020] EWHC 2308 (TCC).