A collateral warranty is a contract under which a party involved in the works warrants to a third party beneficiary that it has fulfilled its obligations under its underlying building contract, subcontract or professional appointment (referred to as underlying contract in this article).

In this article we explore the purpose and typical content of a collateral warranty in the context of a construction project. We also briefly consider an alternative approach as provided by the Contracts (Rights of Third Parties) Act 1999.

Purpose

In a simple construction project, an employer may contract with a contractor to carry out building works. Those two parties usually have a clear contractual relationship.

However, construction projects invariably involve a wide range of parties with an interest in the development (funders, purchasers, tenants for example) and also those involved in the works (contractors and consultants). Some of those parties will not have a direct contractual link or a commercial relationship of any sort.

Ordinarily, only a party to a contract is entitled to enforce said contract. Therefore, if a subcontractor were to commit a breach of its subcontract (with the contractor), and that breach adversely impacted on the employer (this could also be a funder/purchaser or tenant), an employer would be unable to enforce the same. That creates a problem for the employer particularly in a situation where the main contractor is insolvent.

In addition, if the employer identify defects in the subcontract works, in the absence of a collateral warranty the employer would have no realistic contractual recourse against any party in the example above.

In the absence of that contractual link, the employer would have to rely on a claim in negligence. This is not desirable as it would require the employer to establish that the subcontractor owed it a duty of care before its claim was even considered. Even if successful, the employer would also be limited as to what it could recover in negligence.

Collateral warranties are used to bridge the contractual gap and create a direct contractual link for the benefit of those parties that may otherwise have no recourse.

The step-in option

Some collateral warranties can also contain ‘step-in’ rights which effectively allow the beneficiary to step in to the underlying contract and issue instructions.

Should the main contractor of a project fall into insolvency the subcontractor will be under no contractual obligation to accept instructions from the employer to complete the works given there exists no contractual relationship. The use of a collateral warranty in this instance creates a direct contractual link allowing the employer to give instructions to the subcontractor, ensuring completion of the latter’s obligations is achieved.

Key contractual considerations

Effectively a collateral warranty is a shortened version of the underlying contract and so should reflect the obligations therein. We would expect to see direct provisions as to:

  1. Principal covenant – The warrantor warrants to the beneficiary that it has and will fulfil its obligations under the underlying contract and perform its obligations with an appropriate level of skill and care.
  2. Insurance - The level/basis of insurance the warrantor is obliged to maintain for the duration of the warrantor’s liability period.
  3. Step-in rights - Gives the beneficiary the ability to step-in to the underlying contract in place of the instructing party in certain circumstances.
  4. Intellectual property licence – A right for the beneficiary to reproduce and use the warrantor’s intellectual property.
  5. Assignment - The ability to ‘pass on’ the benefit of the warranty to an alternative third party beneficiary.
  6. Materials – That materials used or specified by the warranting party will be or were fit for use and not deleterious in nature.

Are parties required to provide collateral warranties?

This is dependent on the terms of the underlying contract. Providing a collateral warranty increases the potential scope of a provider’s liability, so careful thought should be given to the decision to do so.

If so required, a party may seek to limit the number of warranties it is obliged to provide, or limit the scope of the same by proposing an overall cap on its liability.

A warranting party (and its insurers) is unlikely to want to extend its obligations in a collateral warranty beyond those contained in its underlying contract. Such clauses are standard in the collateral warranties we see.

If entering into a collateral warranty, it is important to seek legal advice to ensure that the terms are acceptable for the required purpose, whether from the perspective of a beneficiary or the warranting party.

Third-party rights - An alternative approach?

A statutory exception to the doctrine of privity of contract was introduced by the Contracts (Rights of Third Parties) Act 1999 (the Act).

The Act allows a third party to enforce the terms of a contract where an express right has been granted or the contract confers a benefit on the third party. The contract should clearly identify any third party beneficiary by name or particular category (eg purchasers or tenants), with such beneficiaries typically set out in a rights schedule annexed to the underlying contract. Any such beneficiary will benefit from any remedy that would be available in an action for breach of contract as if they were a party to said contract.

Granting rights under the Act, particularly to members of a class, may result in the construction of a wide range of third party beneficiaries, which may place undue risk on the warrantor. While such rights are sometimes granted, contractors and consultants typically prefer to exclude them entirely by an express term of the contract, instead relying on collateral warranties.

Conclusion

Collateral warranties will continue to act as useful security in construction projects, allowing a beneficiary to avoid the issues associated with bringing a claim in negligence if issues arise.

Both collateral warranties and third-party rights can extend the scope of a warranting party’s liability beyond its direct employer, which may be beyond what was perhaps initially anticipated. While construction professionals generally accept that collateral warranties, or third-party rights, form part of a typical construction suite of contracts, the scope of additional liabilities to third-party beneficiaries should be factored in to the agreed price when negotiating an underlying contract.