Third parties need to carefully consider the precise wording of contractual protections to avoid losses disappearing into contractual black holes

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A recent decision of the Technology and Construction Court highlights the importance of carefully planning procurement structures, and providing for interested third parties to be given direct contractual rights against construction parties, as the transferred loss principle is unlikely to be available to plug any black holes arising in connection with construction contracts that include clauses concerning the disapplication of third-party rights.

The Stepping Stone Group Ltd (SSGL) contracted Dr Jones Yeovil Ltd (DRJ) to build and refurbish some assisted living units. The work was procured under three separate contracts on amended JCT Design and Build 2005 and JCT Minor Works 2011 terms. The property was owned by NCL, a subsidiary of SSGL. After completion, NCL disposed of the units on long leases.

A dispute arose between SSGL and DRJ in connection with defective work. In its defence DRJ claimed that SSGL had not suffered the loss complained of, as it was neither owner nor occupier of the units. The loss was actually suffered by the leaseholders, and in the absence of the leaseholders having rights against DRJ to recover their losses DRJ argued their losses fell into a contractual black hole.

SSGL sought to rely on the principle of transferred loss to enable it to recover losses suffered by the leaseholders. This principle applies where one party to a contract agrees to confer a benefit on a third party and it can be shown that there was a common intention and a known contractual object to benefit the third party. In such circumstances the third party’s loss may be recovered by the other party to the contract, acting as an exception to the general rule that a party can only recover losses it has suffered itself. SSGL argued that the development was ultimately for the benefit of the leaseholders, bringing them within the scope of this principle.

The principle applies where it can be shown that there was a common intention and a known contractual object to benefit the third party

The court rejected SSGL’s submission. 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”. 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.

As procurement structures become ever more complex, the potential for contractual black holes to arise continues to increase. Typically, employers and interested third parties will seek to put in place contractual mechanisms to avoid such black holes and the need to rely on the transferred loss principle. This can be achieved through procuring collateral warranties/third-party rights (TPRs) from the construction parties to interested third parties, or through assigning on the benefit of the original construction contracts. However the provision of direct contractual rights will not always be sufficient to avoid problems with contractual black holes.

As procurement structures become ever more complex, the potential for contractual black holes to arise continues to increase

An issue arises where a warranty/TPRs contain a clause which provides that the construction party shall owe no greater liability to the beneficiary under the warranty/TPRs than it owed to the employer pursuant to the underlying construction contract. Such clauses are commonly used to ensure that any limitations on liability in the underlying contract will also apply to claims under the warranty/TPRs, but they can also 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 that ensure 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, because 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 parties are on terms that avoid no-loss arguments arising, regardless of the nature of development obligations owed elsewhere on the project.

Rebecca Prigg is a senior associate in the construction and engineering team at CMS