A joint real estate development project usually involves two legal relationships: (1) a joint development agreement between the party who contributes the land use right (the “land owner”) and the party who finances the development (the “financier”); (2) a construction contract between the developer (usually the financier) and the contractor. In practice, the land owner is usually not a party to the construction contract and is not involved with the construction. However, if the developer defaults on its payments to the contractor, the contractor often sues both the developer and the land owner, holding the land owner jointly and severally liable. The admissibility of such a claim is determined by the court. The outcome will depend on whether the court applies the doctrine of privity to the construction contract.
In a case on which we advised recently, the courts of first and second instance broadened the doctrine of privity and ruled in favour of the contractor. There was no clear legal basis for this decision.
I. Case summary
In 1994 and 1995, a land owner and a developer entered into a series of preliminary agreements on the joint development of a property. Under the Joint Development Agreement, the developer was to provide all funds needed for the project and the land owner was responsible for the right to use the land. On completion of the project, profits were to be split between the two parties proportionally.
On 21 June 1996, the developer signed a construction contract (the “Construction Contract”) with a contractor. A payment dispute arose between the contractor and the developer and on 14 August 2002, the contractor filed a lawsuit, claiming payment of the principal plus interest on the overdue amount from the developer and for joint and several liability to be borne by the land owner.
II. The dispute
The land owner, as a party to the Joint Development Agreement, was only responsible for providing the right to use the land. The land owner did not sign the Construction Contract and had no involvement in the construction. The Joint Development Agreement expressly stated that all funds for the project would be provided by the developer. The developer signed the Construction Contract with the contractor. The issue was whether the land owner was jointly and severally liable for the developer’s default on payments to the contractor.
1. The contractor claimed that the Construction Contract was lawful and valid, and that they had fully performed their obligations under the contract. They argued that the land owner, who partnered with the developer to develop the project, had shared profits from the development and construction. Therefore, they should be jointly and severally liable for the construction payments.
2. The land owner argued that:
- They were not a party to the Construction Contract, only to the Joint Development Agreement, to which the contractor was not a party. Therefore, there was no contractual relationship between the land owner and the contractor.
- According to the doctrine of privity, a contract cannot confer rights or obligations on any person or agent not a party to it. Therefore, the land owner could not be liable for any debts arising from the Construction Contract.
- Under the Joint Development Project, the profit allocated to the land owner was consideration for the right to use the land given to the developer by the land owner. It could not be used to hold the land owner jointly and severally liable for the developer’s default on payments.
IV. Court judgments
1. First-instance judgment
The developer and the land owner were in partnership. They both engaged in the development and both gained profits. This constituted joint development. As partners, the developer and the land owner should be jointly and severally liable for any debts to third party creditors. Since the land owner profited from the construction, they must be jointly and severally liable for the developer’s default on payments.
2. Second-instance judgment
The developer and the land owner were joint developers of the project. Both parties profited from the development. Based on the principle of equity, the internal agreement between the developer and the land owner should not be used against external creditors. Therefore, the land owner is jointly and severally liable for the developer’s default on payments.
V. Our views and advice
1. “The land owner sharing profits from the project” is not a valid ground for the courts to make an exception to the doctrine of privity. The first- and second-instance judgments lack a good legal basis.
- In this case, the land owner had no involvement with the construction. They did not execute or perform any part of the construction contract. Nor did they voluntarily participate in the project or undertake any liability connected with it as a party to the contract.
- Article 84 of the General Principles of the Civil Law of the People’s Republic of China and Article 8 of the Contract Law of the People's Republic of China , codified the doctrine of privity into Chinese law confirming thatThere were no statutory circumstances in this case that allowed immunity from the doctrine of privity. The court erred in law by holding that the land owner’s sharing in profits from the project” was such a circumstance.
- The profit the land owner received from the project was merely consideration for its contribution to the project of the right to use the land. The courts, however, used this as a ground to hold the land owner jointly and severally liable for the debts arising from the project. Such liability does not stem from the consideration forthe right to use the land. In holding the land owner liable for the debt, the court has modified the consideration between the parties to the Joint Development Agreement. This is an interference by judicial powers in the free bargaining of equal parties and an agreed compensation for the value each party contributed .
- Following the court’s reasoning in this case, homeowners who have bought properties from this development would also be jointly and severally liable because they also benefited from the project. Obviously, this is illogical.
2. The Supreme People’s Court decision in a similar case supports our view.
In the Civil Judgment (2007) Min Yi Zhong Zi No.39 the Supreme Court found:
- The dispute concerned the construction contract, not the joint development contract. The construction contract was binding only on the parties to the contract and had no legal effect on any other party.
- There was no evidence that the land owner became a co-developer by substituting the developer or participating in the performance of obligations under the construction contract.
- The parties to the joint development agreement performed their obligations under the agreement. The statement of “joint investment and shared profits and risks” relates only to the parties to the joint development agreement and has nothing to do with any third parties. The land owner and the developer did not enter into an individual partnership or form a partnership enterprise for the joint development and therefore the joint and several liability clauses of the General Principles of the Civil Law of the People’s Republic of China and the Law of the People’s Republic of China on Partnership Enterprises did not apply here.
3. Advice for land owners
Though we disagree with the first and second instance judgments above, land owners need to be aware that the court may break through the doctrine of privity and hold a land owner jointly and severally liable, if the land owner has profited from a joint development and in the interests of fairness. We advise :
- In a joint development agreement, the land owner should ensure that any possible liability arising from construction activities in the joint development is borne by the developer only. The land owner should also ensure that it is indemnified for any loss arising from the developer’s default;
- Before entering a joint development agreement, the land owner should require the developer to obtain a letter of undertaking from the contractor. The letter should state that the contractor has been informed that any liability arising from the construction will be borne by the developer. It should contain a guarantee that the contractor will not make a claim for overdue payments against the land owner;
- During the term of cooperation, the land owner should monitor the payment process to reduce default risk;
- The land owner should withhold a portion of the developer’s profits as payment provisions. So, if a land owner is unfortunately held jointly and severally liable for the developer’s defaults, they can use the withheld profits as compensation.