Collateral warranties in construction projects

This article will examine collateral warranties in construction projects, why they are important and when they should be put in place. We also explore potential alternative solutions such as the issue of third party rights notices and the advantages and disadvantages of these compared to collateral warranties.

What is a collateral warranty and why are they used?

Prior to a construction project, depending on the type of procurement process used, the employer (the party procuring the project such as a property developer) will usually enter into contracts with consultants and contractors to carry out various types of work. The underlying contract could be a construction contract (such as a JCT), professional appointment, a sub-contract or sub-consultancy agreement. The type of work could be architectural design, electrical installation, foundation works or many others. The employer (or in some cases the contractor, where sub-contractors are appointed) will have a direct contractual relationship with the parties to these underlying contracts and be able to seek redress if something goes wrong.

In addition, there are often many other interested parties in construction projects including funders, purchasers, tenants and others, often referred to as “beneficiaries”. These parties will often not have a direct contractual link to those carrying out works and therefore if something goes wrong with the project they will not have a contractual redress. Consider for example a project to build a new development of offices in the City of London, supported by development finance from a lender, and the employer employs an architect to design the project. Once the office block is completed it is found that the design of the building is defective and there is subsidence on one side. Expensive remedial work must be carried out before the building can be occupied.  As a result, the employer becomes insolvent and the funder faces having to recover its investment by completing the build. The funder does not have a direct contractual relationship with the architect, so in order to recover the costs of rectification of the design defect the lender would have to try to sue the architect in the tort of negligence. This would require the funder to prove that the architect owed a duty of care to them and the funder had relied upon the architect’s services – not by any means a simple proposition – and even if successful, the funder would be limited in terms of the amount it could recover.

As such, the parties involved often look to put in place collateral warranties, meaning that the beneficiary can sue in contract rather than tort. Collateral warranties are secondary contracts, usually annexed in a prescribed form to the underlying contract, that create a direct contractual link between the beneficiary and the party providing services or works, and are signed by all parties.  Collateral warranties typically include a requirement for the consultant to maintain sufficient professional indemnity insurance and the right for the third party to “step into the employer’s (or contractor’s) shoes” in certain situations in order to bring the project to completion. These are extremely common in construction projects where margins are tight and the failure to complete on time and budget can lead to insolvency.

Are collateral warranties a requirement?

This is dependent on the terms of the building contract and the terms under which parties are appointed to work on a construction project.

On larger construction projects, employers will sometimes insist on collateral warranties from sub-contractors to protect against contractor insolvency. A collateral warranty in this situation would enable the employer to ‘step in’ to the sub-contract to try progress the works to completion.  A step-in right allows a beneficiary to take over the employer’s role on a project if it is insolvent or does not comply with the professional appointment or building contract

Agreeing to provide  collateral warranties will increase the potential scope of beneficiaries with a right to sue, so is not something to be entered into lightly, particularly if the value of the work on a project being carried out is relatively low. A contractor or consultant is unlikely to want to extend its liability under a collateral warranty beyond those contained in its underlying contract due to concerns about insurance coverage. Before entering into a collateral warranty, a contractor or consultant should seek legal advice to ensure that its terms are fair and it does not extend any liability beyond the original contract.

In English law, deeds are enforceable for 12 years after the date of any breach, whereas breaches of a simple contract are only enforceable for 6 years after any breach. Employers and beneficiaries will therefore want collateral warranties to be in the form of a deed to maximise the duration that the collateral warranty can be enforced.

Contractors usually attempt to limit liability to no greater amount that the underlying contract – a ‘no greater liability’ or ‘equivalent rights’ clause – or include a top line cap on recoverable liability under the collateral warranty.

On the other hand, a beneficiary will want to ensure that contractors cannot evade any responsibility under a collateral warranty and will try to ensure it is as comprehensive as possible.

What is a collateral warranty comprised of?

The following are typical provisions in a collateral warranty:

1) Performance obligations: the collateral warranty will usually include a provision whereby the contractor agrees to comply with the underlying contract. Consultant collateral warranties will usually include a provision whereby they will agree to carry out and perform the services under the appointment with reasonable skill, care and diligence in accordance with the normal standards of the consultant’s profession.

2) Insurance requirements: the collateral warranty will usually require that the contractor or consultant maintains an appropriate level of professional indemnity insurance for a specified period, aligned with the limitation period. This provides the beneficiary with the comfort of knowing that the protection under the collateral warranty is insurance-backed throughout the limitation period.

3) Non-variation clause: the collateral warranty will usually include a provision whereby the contractor or consultant agrees not to vary, amend, waive, or supplement the terms and conditions of the original contract without the prior written consent of the beneficiary.

4) Assignment rights: the collateral warranty may allow the beneficiary to assign the collateral warranty to another party, typically without the consent of the contractor or consultant. This is important if the beneficiary wants to transfer the agreement in the case of a sale or re-financing. This is usually limited to assignments of the benefit of the collateral warranty on no more than two occasions (save for assignments by way of security or intra-group assignments) as the parties want to balance the flexibility requirements of the employer with the contractor’s desire not to be exposed to claims by multiple different consecutive parties.

5) Step in rights: collateral warranties can also include ‘step-in’ rights which effectively allow beneficiaries to ‘step in’ to the underlying contract and issue instructions to contractors or consultants in order to complete the project. Should the employer become insolvent, without step-in rights the contractor or consultant would be under no contractual obligation to accept instructions from the beneficiary to complete the works. The use of a collateral warranty enables the funder (in the example above) to give instructions and payment directly to the contractor or consultant, allowing the project to be completed and the investment potentially recouped.

6) Copyright licence: collateral warranties will usually grant the beneficiary licences to copy and make use of any designs, drawings and other materials produced in connection with the works. If the collateral warranty does not include these provisions, a beneficiary such as the employer attempting to ‘step in’ to the building contract may not be able to use and make copies of the designs, drawings and other materials.  As with the other provisions in a collateral warranty the copyright licence provisions should be the same as equivalent provisions in the building contract to which it relates, otherwise the contractor may be able to rely on the ‘no greater obligations’ and ‘equivalent rights’ provisions discussed above to avoid liability under the collateral warranty.

Third party rights

Another option for parties in construction contracts is to rely on the Contracts (Rights of Third Parties) Act 1999. A contract cannot impose a duty on a non-party, or bind a non-party to give up any right, but the Act allows third party beneficiaries to enforce the terms of a contract where that contract expressly confers a benefit on a third party or where an express right to do so has been granted. This is achieved by clearly identifying the third party beneficiary (such as a lender, developer or purchaser) in the terms of the contract, annexing a schedule of specific rights  and a proforma notice which is issued in order to confer those rights. Once the notice is issued, the beneficiary will be able to enforce the rights in the third party rights schedule. The third party rights schedule and notice will also need to be carefully drafted to ensure that the beneficiary will enjoy the right of step-in if required without being subject to challenge.

The unilateral issue of the third party rights notices means that the contractor or consultant does not play a part in the process of issuing third party rights, and if drafted widely, the definition of “beneficiary” can include parties to whom it would be unfavourable for them to owe third party rights. Many contractors and consultants therefore prefer to expressly exclude the Act and use collateral warranties (which are signed by all parties) instead.

Letters of reliance

Those providing one-off professional services such as surveys and other deliverables provide letters of reliance rather than full collateral warranties. Letters of reliance are often used where a consultant has prepared a report(s) and a beneficiary wants to be able to rely on these reports. The consultant may not have been appointed on terms and conditions that allow the beneficiary to require a collateral warranty to be entered into, or may be unwilling to give a collateral warranty due to the value of the work carried out. The letter of reliance will warrant that the consultant will carry out the work to a reasonable standard of skill and care appropriate for the type of work being carried.

Conclusion

Despite the alternative available options, collateral warranties will continue to act as useful security in construction projects, allowing interested parties in projects to obtain remedies through the courts or to step in if problems arise. Please contact our experienced construction team for further advice on this complex area of the law.