Demystifying collateral warranties

29 October, 2012

Love them or loathe them, collateral warranties are still the main method of granting protection to third parties with an interest in a construction project.  This article aims to demystify what collateral warranties are, why they are needed and explores the more cost-effective alternative of using third party rights schedules. 

 

What is a collateral warranty and why are they needed?

Put simply, a collateral warranty is a contract under which a building contractor, a professional consultant (such as an architect or structural engineer) or a sub-contractor warrants to a third party that it has complied with its building contract, appointment or sub-contract.

Any construction project typically involves a number of parties with different interests in the completed works.  The party that directly employed the building contractor (usually the employer), the professional consultant (usually either the employer or the main contractor) or the sub-contractor (usually the main contractor) is given protection against defective design or construction through the obligations set out in the building contract, appointment or sub-contract.  However, for other parties with an interest in the project, there is no direct contractual link with each construction professional as only the original parties to each contract can rely on its terms. 

Such third parties may include a party providing finance for the works (funder), a party purchasing part or all of the completed works (purchaser) or a party taking a lease of part or all of the completed works (tenant).  If there is a mistake by a construction professional in the design or construction process resulting in a defect in the completed works, a funder or purchaser may incur losses through a reduction in the capital value of the completed project, whilst a tenant may be hit by high service charges or an unwelcome repair bill if it has accepted repair responsibility for the affected part of the building. 

There is a long line of case law which has established that if a third party suffers financial losses in these circumstances, it may not be able to recover the cost of putting the work right without a direct contractual duty of care from the construction professional at fault.  The collateral warranty acts to plug this gap by providing the necessary duty of care and allowing a breach of contract claim. 

 

Common features of a collateral warranty

Whilst the main purpose of a collateral warranty is to grant a third party a contractual duty of care from the building contractor, professional consultant or sub-contractor, this is not their only role.  A typical collateral warranty also includes:

 an obligation on the party giving the collateral warranty not to specify and/or use any prohibited materials;

 a requirement to maintain professional indemnity insurance at a level usually matching the insurance requirement under the main contract or appointment;

 a copyright licence allowing the recipient of the collateral warranty to copy and use any design documents produced by the party giving the collateral warranty for the works;

 a requirement to supply further collateral warranties if requested (usually granted to a funder or purchaser);

 step-in rights, which allow the recipient of the collateral warranty to take over employment of the party giving the collateral warranty in specific circumstances (usually given to a funder or purchaser in case the project’s developer becomes insolvent).

In addition, the construction professional giving a collateral warranty may require a “no greater liability” clause to be incorporated.  This provides that the professional is under no greater liability to the recipient of the collateral warranty than it is to the party employing it under the original contract.  It may also seek to include additional exclusions or limitations on its liability, such as net contribution clauses, overall caps on liability and prohibitions on the recovery of consequential losses or delay damages.

There are a number of drafting bodies that have produced their own standard form collateral warranties for use, for example the JCT and CIC, but often employers and funders will insist on bespoke warranties being used which offer them greater protection.

 

Third party rights schedules

Whilst offering important protection to third parties, the process of using collateral warranties can be frustratingly slow and expensive.  A large commercial project can involve numerous construction professionals and commercial properties in multiple occupation (for example, office buildings or shopping centres) may have multiple parties all requiring a collateral warranty package.  Each collateral warranty must be negotiated, prepared and circulated for signature by two or three parties, with construction professionals often dragging their heels over signing them.

There is an alternative method available to give third parties the same rights through the Contracts (Rights of Third Parties) Act 1999. It is somewhat surprising that the construction industry is still reluctant to replace the use of collateral warranties with the use of this Act.

The Act works by allowing a person who is not a party to a contract to enforce the terms of that contract if the contract expressly provides that it may do so or purports to confer a benefit upon the third party.  The third party must be clearly identified in the contract, either by name or as a member of a particular category of beneficiary.

In practice, this means that it is possible to include within a building contract, professional appointment or sub-contract a schedule of benefits specifically for third parties.  This list would contain rights similar to the rights set out in a collateral warranty.  It also identifies a list of categories of beneficiary who can benefit from the rights (for example, funders, purchasers and tenants). A mechanism is set out enabling the employer under the construction contract to serve a notice on the professional informing them of the identity of the beneficiary, once known.  The service of this notice will then automatically confer the rights set out in the schedule on that named third party.

This significantly cuts back on the amount of administration and time and expense associated with collecting collateral warranties. Everything in the construction contract is prepared at the outset.  There is no waiting around for collateral warranties to be signed, a simple notice is the only document that has to be prepared.

 

Drawbacks to third party rights schedules

Whilst now increasingly used, there is still a certain reluctance to use the Act.  Funders and insurers in particular are still unwilling to rely on rights conferred by the Act and prefer to receive collateral warranties.  There is not a great deal of case law on the use of collateral warranties themselves but the operation of the Act in a construction context is largely untested in the courts, giving rise to nervousness about its use.

There is also some concern in the industry that step-in rights may not be effective as the Act can only pass on benefits and not burdens, which a step-in mechanism often requires (for example, it may require the beneficiary to serve notice at certain times).  Most legal practitioners though are confident that step-in rights can be drafted so as to avoid this problem.

If you are drafting a construction contract or appointment, you may not wish to rely solely on the Act in case some funders, buyers or tenants are insistent on being provided with a collateral warranty.  To this end, many employers incorporate in their construction contracts a mechanism using the Act coupled with a right to ask for a collateral warranty if necessary.  That way, all bases are covered.

 

Summary

Whether the rights are given through collateral warranties or the Contracts (Rights of Third Parties) Act 1999, the value for a third party with an interest in a construction project of having direct contractual links with the professional team should not be underestimated.  Without them, the third party may (in the absence of latent defects insurance or an indemnity from its landlord, seller or borrower – topics justifying separate articles) be exposed to defects emerging in the completed building without any contractual recourse against the original project team.  The use of the Act is becoming increasingly popular but it seems that collateral warranties will still be around for some time to come. 

 

 

Reviewed in 2015