News & Insights

Collateral warranties

Collateral warranties are firmly embedded as a feature of construction projects, particularly those requiring development finance, but what is a collateral warranty, why do they exist and are they really necessary?

What is a collateral warranty?

A collateral warranty is a secondary contract usually given by main contractors, sub-contractors and professional consultants in relation to construction projects. Collateral warranties are so called because they warrant (i.e. affirm) the effect of certain terms in the underlying contracts to which the warranty is collateral.  In the case of a warranty given by a main contractor, the underlying contract would be the building contract; in the case of a warranty given by an architect, the underlying contract would the appointment.

Collateral warranties are commonly granted in favour of developers, funders, tenants, future purchasers and mortgagees of future purchasers of the project in question.  The crucial point to note is that in each case the warranties are granted in favour of certain parties who have an interest in the project but are not a signatory to the underlying contracts.

Common forms of collateral warranty include standard forms produced by the British Property Federation, JCT and the Construction Industry Council.  There are also numerous bespoke forms of warranty.

Why are they necessary?

Collateral warranties are necessary to protect third parties with an interest in the project because of the law of privity of contract.  The effect of privity is that a person (be it a legal person such as a company or a natural person) may not enforce the terms of a contract unless that person is also a party to that contract.  This can cause problems in a development context where, for example, a tenant enters into an FRI (full repairing and insuring) lease of a new build property but does not have a contractual relationship with the project team that designed and built the property.  If, subsequently, a defect arises in the property due to the negligence of the design team, the main contractor or a sub-contractor, then without further contractual protections the tenant will not be able to bring a claim to compensate it for the fact that, under the terms of its lease, the tenant is liable to pay for the costs of repair.

Collateral warranties were conceived in order to give third parties in such situations (referred to in warranties as ‘the beneficiary’) a contractual right to bring a claim against the project team (‘the warrantors’), where otherwise there would not have been such a right, in the event that a defect arises in the property.  It is important to note that the existence of a warranty does not guarantee that a claim brought by the beneficiary will be successful – the beneficiary still has to prove in the usual way that the individual warrantors (or at least one of them) were responsible for the defect that caused the loss.

What do they say?

Collateral warranties usually contain at least the following provisions:-

– A duty of care – perhaps the most important clause in a warranty from the beneficiary’s perspective.  This is the clause that permits the beneficiary to rely on the warrantor having undertaken the works and/or design using reasonable skill and care, and to bring a contractual claim against the warrantor in the event that the works and/or the design is defective.

– A provision that the warrantor has not used or specified for use any deleterious materials (being any materials that may be harmful to either people or the building itself) in the project.

– In some cases, step-in provisions.  These entitle the beneficiary to step into the shoes of the party who is employing the warrantor in order to ensure that the development is completed in the event that the employing party becomes insolvent.  This is a particularly important provision for banks providing development finance and for forward funding purchasers.

– If the warrantor has undertaken design responsibilities, then there should be a clause granting the beneficiary a copyright licence to use the designs in connection with its future use of the building, and also an obligation on the warrantor to maintain professional indemnity insurance in a specified amount to cover its liabilities in relation to those designs.

– A clause specifying how many times the benefit of the warranty may be assigned (for example, to a future purchaser of the property).  Commonly two assignments without the consent of the warrantor are provided for.

– On occasions, the warranty may contain a net contribution clause or a limit of liability clause, which are both mechanisms seeking to restrict the warrantor’s financial exposure in the event that a claim is brought under the warranty.  The acceptability of such clauses will depend on whether you are the party giving the Warranty or receiving it!

Do we need them?

Although it is usually essential for the types of third parties outlined above to be provided with contractual protection in relation to construction projects, collateral warranties do carry a number or disadvantages.  Perhaps the most significant of these is the fact that provision of warranties to each party interested in the project requires the drafting, and thereafter the negotiation, of an enormous number of documents.  This can be extremely time consuming from a solicitor’s perspective, which inevitably leads to significant costs being incurred.

An alternative to this is to invoke the Contracts (Rights of Third Parties) Act 1999, which allows the underlying contract to grant rights in favour of third parties who are not signatories to it, rather than producing separate documents that are collateral to that contract.

Once an appropriate provision has been included in the underlying contract, then the provision of the rights to the interested third parties is triggered by means of a one page notice that is served unilaterally by the employing party.  This greatly reduces the amount of paperwork and does away with the need for any negotiation once the underlying contracts have been entered into.  The result is a significant time and cost saving, with the further advantage that the interested party is provided with its contractual protection much quicker than would be the case with traditional collateral warranties.

Currently, despite the fact that the Contracts (Rights of Third Parties) Act came into force in 2000, the construction industry has not been particularly quick to rely on its provisions in lieu of collateral warranties.  However, there is no reason why this should be the case and the reluctance is gradually being eroded.  The provision of contractual protections to interested third parties in this way is, therefore, something that should be considered by all employers and funders at the outset of a project.