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‘Black holes’ on construction projects – The gravity of the situation

The TCC’s recent decision in Dr Jones Yeovil Limited v The Stepping Stone Group Limited is a useful reminder of the issues posed by legal “black holes”.

What is a “black hole” in contract law?

It is a fundamental principle of English law that damages for a breach of contract are to put the innocent party in the position that it would have been in had the other party complied with its obligations under the contract.  Damages should compensate for loss incurred.  So, if there is no loss, then the claimant should only receive nominal damages even if the defendant is in breach of their contractual obligations.

In construction projects, the no loss argument can lead to a contractual “black hole”, even if the defendant’s actions have caused the claimant to suffer serious losses.

One way a black holes may arise is where the developer is a separate legal entity to the owner of the land. In this case it may be argued that the developer (the entity with a contractual claim against the contractor/consultant responsible for the defect) has not suffered a loss, as it doesn’t own the works in question and isn’t under any obligations to repair. This risk can be mitigated by the developer entering into a development agreement which provides obligations to the owner of the land so that the loss incurred by the owner can then be passed to the developer. However, the developer may seek to restrict its liability period under such an agreement to only a limited period following practical completion.  Another way to avoid such a black hole is to require all the relevant contractors and consultants to enter into collateral warranties with the owner of the land so that it can claim against the relevant contractor and/or consultant directly.

Transferred loss

In order to avoid such situations where a ‘black hole’ may arise, the courts have developed a number of principles, including the principle of “transferred loss”. Transferred loss is a complicated area of evolving case law, but essentially it can be divided into a “narrow” and “broad” ground. The narrow ground enables an employer to claim on behalf of a third party purchaser where the purchases are foreseeable at the time of entering into the building contract. The broad ground applies where, at the time of entering into the contract, the parties have a common intention and/or a known objective to confer a benefit to an independent third party.  

Dr Jones Yeovil Limited (DRJ) v The Stepping Stone Group Limited (Stepping Stone) - Background

DRJ was employed by Stepping Stone to carry out works on a number of assisted living units. The property on which the assisted living units were constructed was owned by NCL, a subsidiary of Stepping Stone and a separate legal entity. After practical completion NCL sold the properties on long leases and retained the freehold of the common parts.

A dispute regarding defective work arose after practical completion. The building contract specified the use of ground source heat pumps.  DRJ had not complied with this specification and instead installed less efficient heat pumps. Stepping Stone claimed against DRJ for the increased energy costs incurred by the leaseholders of the units as a direct result of the less efficient heat pumps.

The court’s decision

DRJ contended that Stepping Stone had in fact suffered no loss, as it was neither the occupier nor owner of the assisted living units. Stepping Stone initially suggested that it had entered into a development agreement with NCL, which contained an obligation to indemnify for defective work. This argument was dismissed as there was no documentary evidence that this development agreement actually existed. Stepping Stone therefore attempted to rely on the broad ground of the transferred loss principle, arguing that at the time the building contracts were entered into, Stepping Stone and DRJ had intended to transfer the benefits under those contracts to both NCL and the purchasers of the assisted living units.

However, the court rejected Stepping Stone’s argument. The court noted that the broad ground of the transferred loss principle was good law, underpinned by the need to provide a remedy for a breach of contract in the interests of giving effect to the object of that contract. However, the court reasoned that, as the building contract contained a clause expressly dis-applying the effect of the Contracts (Rights of Third Parties) Act 1999 (pursuant to which contractual rights may be conferred on identifiable third parties), there was a positive disclaimer of the known third party benefit. Therefore, the broad ground of the transferred loss principle could not apply.

Going forward

As ‘boilerplate’ clauses dis-applying the effect of the Contracts (Rights of Third Parties) Act 1999 are ubiquitous in UK construction contracts (and for good reason), the broad ground of the transferred loss principle is unlikely to assist parties in the future who find themselves in Stepping Stone’s position.

The court’s decision in this case demonstrates the importance of collateral warranties and third party rights agreements in construction projects where the loss may fall on a party with no contract with the defendant. Had NCL or the residents had the benefit of collateral warranties or third party rights from DRJ, they would have been able to recover their losses directly, rather than passing them on to Stepping Stone to pursue. As such, while the preparation, negotiation and execution of collateral warranties and third party rights agreements might seem a laborious exercise during a project, their worth should not be overlooked.

This article was written by Sam Johnson. Please do not hesitate to contact Sam, or your usual Charles Russell Speechlys contact if you have any queries. 

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