Tenants and collateral warranties – when should a tenant insist on a collateral warranty?

Construction security

A tenant taking out a commercial lease on a full repairing and insuring basis will want to ensure that it has the required construction security in the event of defective design or workmanship by a contractor or a consultant involved in the construction or refurbishment of the commercial unit. In accordance with the third party rule, only parties to a contract can acquire directly enforceable rights or obligations under the contract, but as the tenant would not have been a party to the construction contracts entered into between the landlord and the various construction team members it needs to seek another avenue to receive any benefit under these contracts.

What is a collateral warranty?

A collateral warranty is a separate contract that stands alongside the primary contract, such as the building contract or a professional appointment. By entering into a collateral warranty with the party employed under the primary contract, the tenant receives the benefit of certain rights under the primary contract with this newly established contractual link.

Collateral warranties will however not create any greater rights or obligations than those already existing in the underlying primary contract. The collateral warranty is therefore only as strong, or in some cases, as weak, as the primary contract and it is therefore important for a tenant to undertake a thorough due diligence of the underlying primary contract so that it is aware of any provisions which may limit the liability of the relevant construction team member under the collateral warranty.

It is also possible for the tenant to be the beneficiary of specific third party rights under the construction contracts. These third party rights operate in the same way as a collateral warranty and allows the tenant to enforce certain terms of the relevant construction contract. The third party rights are most commonly set out in a schedule to the construction contract and the construction contract will expressly state that the rights contained in the schedule can be enforced by the third party.

What does a collateral warranty cover?

As mentioned before, collateral warranties need to be consistent with the primary contract to which it relates, but collateral warranties most commonly included the following provisions:

• A warranty by the warrantor that it has and will continue to fulfil its obligations under the underlying contract, including a warranty that any design element of the work will be exercised with reasonable skill, care and diligence.
• Confirmation that the beneficiary (in this case, the tenant) may not give any instruction to the warrantor.
• The granting of a copyright licence by the warrantor to the beneficiary to use or reproduce any of the designs, drawing or other documents produced in relation to the development.
• An obligation on the warrantor to maintain professional indemnity insurance  – provided an element of design is included in the warrantor’s work.
• A limitation on the beneficiary’s right to assign the collateral warranty.

Is a collateral warranty necessary?

The contractual liability under a construction contract is often for a period of 12 years from practical completion of the project and a similar liability period may therefore apply under the warranty. A tenant taking out a lease of a commercial unit constructed or refurbished within the last 12 years should therefore consider whether it requires a collateral warranty from any party involved in the construction/refurbishment of the property and ensure that the lease agreement includes an obligation on the landlord to procure such collateral warranties from the relevant construction team members.

Please contact Cathrine Ripley in FSP’s construction team if we can help with any of the topics in this note.