Why are collateral warranties necessary?
Only the parties to a contract can generally sue to enforce the rights and obligations under it. This means that parties do not have to worry about unexpected claims from third parties. However, it can mean that where a third party has an interest in a construction project – for example, a funder or a tenant – then that third party may not be able to bring a contractual claim against the person who is at fault, as he has no rights under the relevant contract.
(Please also see "The Contracts (Rights of Third Parties) Act 1999" below.)
What does a collateral warranty do?
This is where the collateral warranty comes in. A collateral warranty is an additional contract between, commonly, a (1) contractor, consultant or subcontractor (warrantor) and (2) an interested third party (beneficiary) giving that third party the right to sue the warrantor. It is a useful contractual bridge which creates a direct contractual link which may not otherwise exist. This helps to provide an additional level of security for other stakeholders in a construction project who are not directly appointing the parties delivering it.
Collateral warranties are given in PPP projects for example by the professional team (for more detail please see Professional appointments in favour of the procuring authority, funders and special purpose vehicle. For more detail on PPP projects please see Public Private Partnerships. They are also given by key sub-contractors.
It is important that a collateral warranty is consistent with the underlying contract it relates to.
What does a collateral warranty contain?
- Principal covenant: that the warrantor will fulfil its obligations under the underlying contract and, without prejudice to that covenant, that it will carry out any design with reasonable skill and care;
- copyright and use of information: third parties acquiring interests in construction projects will require the right to use the design information generated by the project. It's common to include clauses to allow for that right which often restrict the use of design documents to purposes connected with the relevant project;
- assignment: without restrictions, the benefit of a warranty can be assigned in the same way as any contractual benefit. Warrantors sometimes request limits on the number of permitted assignments of collateral warranties to seek to limit the number of third parties they may become liable to; For more detail on assignment and novation in construction contracts please see Assignment and novation:
- step-in rights: these are a common feature of warranties and are often given to beneficiaries who have an interest in the project before it is completed (eg they have provided funding). They give the beneficiary the right to take the place of the employer under the underlying contract, to ensure that it and the project continue, where the employer gets into difficulties that threaten the project. The beneficiary will take responsibility for any past and future unpaid sums under the contract. Step-in provisions often try to postpone the exercise of the warrantor's rights to terminate the underlying contract. This is to give funders time to react to the relevant issue and to make sure that they can exercise the step-in rights. If two or more parties have step-in rights under different collateral warranties (for instance funders and procuring authorities in PPP projects), there should be agreement on whose rights will take priority on step in;
- limitation/exclusion of liability: there are a wide range of limitation/exclusion clauses that can be proposed/considered when negotiating a collateral warranty. Some of these are mentioned below. Whether or not such a clause is acceptable will depend upon the bargaining position of the relevant parties and the beneficiary's view on market practice. For further information on these issues, please see Exclusion and limitation clauses and Direct and indirect loss for contractors:
- no greater liability clause: the warrantor seeks to ensure that it takes on no greater risk as a result of giving a collateral warranty than it has under the primary contract;
- equivalent rights of defence clause: the warrantor seeks to ensure that it has all the same rights of defence against claims under the collateral warranty as it does under the underlying contract;
- economic and consequential loss: These types of exclusions are resisted by beneficiaries, and their appropriateness will depend on the project-specific issues;
- net contribution clause:
- if two warrantors are each liable to a beneficiary for the same defective work, the beneficiary could seek to recover 100% of its damages from warrantor 1, despite the joint liability of warrantor 1 and warrantor 2 in relation to the relevant defects. Warrantor 1 could then seek to recover a share of those damages from Warrantor 2 through the Civil Liability (Contribution) Act 1978;
- a net contribution clause can take various forms. However, it will often state that where two or more warrantors involved in a construction project are each jointly liable for the same defect, the liability of each warrantor will be limited to the amount which would be just and reasonable (having regard to their contribution to the problem). This means that a beneficiary has to pursue each warrantor who may have contributed to the defect. Effectively this transfers the burden of pursuing the other defaulting parties for their contribution from the warrantor to the beneficiary and can be problematic if the one of those defaulting parties is insolvent. This is why net contribution clauses are often resisted by beneficiaries.
The Contracts (Rights of Third Parties) Act 1999
The Contracts (Rights of Third Parties) Act 1999 was primarily aimed at the construction industry, to do away with the need for collateral warranties on each construction project. In broad terms, the Act provides that a person who is not a party to the contract may enforce a term of the contract if:
- the contract expressly provides that he may; or
- the contract term purports to confer a benefit on him.
The Act has not had as big an impact as originally thought, and is often expressly excluded in contracts. The fear was largely driven by the insurance industry, that the Act might inadvertently give rise to additional liability on contracting parties and increased claims against them by third parties. There is still little case law on the operation of third party rights and collateral warranties remain the most common mechanism to give third parties contractual rights of recovery in relation to construction projects.