REUTERS | Jacky Naegelen

Retentions under scrutiny and the transferred loss principle

In this challenging economic climate, contractors are striving to keep their businesses afloat. Healthy cash flow is key and a major barrier to achieving this can be the slow release of (or indeed the failure to release) retention.

The idea of a retention in theory is simple: a way of incentivising the contractor to return to site to remedy outstanding defects and/or complete the project. If it fails to do so, the employer is not left high and dry. Provision for retention is routine in a number of standard forms including many in the JCT family and in NEC4 Option X16.

But, as with many good ideas, the problem comes with their operation in practice. The February 2020 summary of responses to the BEIS 2017 consultation on the practice of cash retention under construction contracts makes a sobering read. It highlights unfair practices surrounding retentions in certain corners of the industry.

And this, remember, is after all of the recent government and industry initiatives introduced to improve payment practices. For example, statutory payment practice reporting requirements, establishing the Small Business Commissioner, refusal to award government contracts to companies who fail to demonstrate prompt payment to their suppliers, the construction supply chain charter, Build UK’s published set of minimum standards on retention, with proposed abolition by 2023 (see Gareth Stringer’s blog on this). The list goes on…

The problems clearly persist, as most recently illustrated by the case of DR Jones Yeovil Ltd v Stepping Stone Group Ltd. Not only interesting from a retention perspective, the case also saw the “transferred loss principle” having a rare outing. This blog takes a look at the case in closer detail.

The facts – a quick recap

The facts are complex and the detail can be found in Practical Law Construction’s legal update.  To briefly recap, the defendant property developer, Stepping Stone Group Ltd, engaged the claimant contractor, DR Jones Yeovil Ltd, under three building contracts (each amended JCTs) to build some assisted living units. The case concerned two of the contracts for Phase 1 and 2 of the works (amended JCT Design and Build contracts (2005 Revision 2)).

The site was owned by Nynehead Care Ltd, a wholly-owned subsidiary of Stepping Stone, which disposed of the individual units on long leases but retained ownership of the common parts.

The works eventually achieved practical completion (in 2011/2012) and half the retention percentage was released (as per clause 4.18.3 of the contracts). Various defects were identified, the contractor accepted a deduction from the remaining retention in respect of certain defects, but the parties failed to agree a final settlement figure.

The contractor commenced proceedings seeking release of the retention. Stepping Stone sought to set-off and counterclaim for alleged losses arising from various alleged breaches of all three contracts by relying on the transferred loss principle.

I will look at the retention issue and transferred loss principle in turn.

Retention

Stepping Stone put forward all manner of arguments as to why the retention should not be released, including:

  • The balance of retention should only become payable as part of the sums due under the Final Statement (which the contractor had not issued).
  • Even if a Final Statement had been issued and become conclusive, Stepping Stone could still deduct sums due in respect of contract breach.
  • The remaining retention was not “an actual sum of money” nor “truly a retention” and so ceased to be payable upon further event.

HH Judge Russen QC made short shrift of these arguments, ruling in favour of the contractor. In a nutshell, his view was that clause 4.18.3 of the JCT contract was clear:  the sum representing the remainder of the retention could not be withheld where the Certificate of Making Good had been issued (or should have been issued). The ability to do so ended upon issue of the Certificate.

Analysis

It seems unconscionable for an employer under a construction contract to withhold payment of the balance of retention from the contractor for more than eight years.

Here, the judge highlighted that Stepping Stone should have put forward its counter-claim arguments independently of any right to retain monies under the contracts. He noted that retention could not be used to provide Stepping Stone with unjustified leverage simply because it was the party in possession of the monies.

Is this a case that adds weight to the argument for the abolition of retention? I don’t think so. Yes, the case shows that withholding retention is open to abuse by employers. But abolishing the retention would not prevent such employers reneging on their other contractual obligations to achieve the same unjust benefit. In my view, the focus should be on the proper administration of the contract to ensure the fair outcome contemplated at the time of drafting such provisions.

Also, in my view, there is currently no real alternative to cash retentions that has gained widespread traction in market:

  • Retention bonds may be the answer for certain, larger projects but these are not normally suitable for smaller projects as they tend to be expensive and can be difficult for smaller contractors to obtain.
  • Likewise, escrow accounts and project bank accounts are often used on larger projects, but their cost and administration can make them an unwieldy choice for smaller concerns.
  • Trust accounts have been mooted as an alternative but have gained little take-up so far.
  • The BEIS consultation favoured a statutory compulsory retention deposit scheme. Work apparently is underway on this, but in the absence of its launch, if retentions are abolished, what is the alternative for an employer who simply wants to make sure it has a ready form of redress should it have to remedy outstanding defects?

With continued judicial guidance on the proper application of retention provisions under the common industry forms of contract, and in the absence of a practical and effective alternative, my view is that cash retentions will continue to prevail as the most common approach. If applied correctly, the contractual mechanism under the JCT forms of contract strikes the right balance between providing security to the employer and granting the contractor the opportunity to make good an exhaustive list of defects and being paid the retention balance.

Transferred loss principle

As mentioned above, another interesting aspect of the case were the discussions surrounding the transferred loss principle. This is where one contracting party (who has suffered no loss) can recover damages from its defaulting contractual counterparty in respect of loss that has been suffered by a third party who is not party to the contract.

Stepping Stone tried to rely on this principle because it did not have a proprietary interest in the site although there was some question over whether Nynehead and Stepping Stone had actually entered into the development agreement.

The crux of Stepping Stone’s argument was that it was entitled to recover the losses suffered by Nynehead (which owned parts of the site affected by some of the alleged defects) and the losses suffered by the leaseholders of the residential units (who were said to have suffered increased electricity bills because of the defective heat pumps).

Again, HH Judge Russen QC dismissed these arguments and ruled in favour of the contractor. The deciding factor was that Stepping Stone had deliberately arranged its affairs to expressly state that the Contracts (Rights of Third Parties) Act 1999 would not apply to the contracts. It had also chosen not to use the collateral warranties or the third party rights available in the standard JCT form. By doing so, Stepping Stone positively disclaimed such third party’s benefit, which made it difficult for the courts to override the parties’ express agreement and rely on the transferred loss principle.

Analysis

It is common for property development and investment transactions to be structured in a way where the site owner (Propco) is different from the entity that enters into the construction contracts (Devco).

In addition to tax considerations, future purchasers of the site by way of corporate purchase of the Propco would find the opportunity more appealing knowing that the Propco is free from contractual development obligations. Such a structure, however, creates a potential legal black hole, which can be remedied by having a robust development agreement between Propco and Devco, creating a chain of contractual obligations through which the losses Propco may suffer can be passed to (for example) a contractor.

Final thoughts

This judgment is a reminder of the care parties should take when administering the retention provisions under their contract. On entering the contract, parties should agree upfront how the retention will be released, and make sure the contract records that agreement.

In addition, before entering the contract, consideration needs to be given to any third parties who will expect to rely on the contractor’s proper performance of its obligations under the contract. Any benefit that is intended to extend to third parties should be drafted for by way of reliance on an obligation to provide collateral warranties and/or third party rights under the Contracts (Rights of Third Parties) Act 1999.

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