Collateral warranties

Collateral Warranties and Third Party Rights

Both third party rights (“TP Rights”) and collateral warranties (“CW”) have the same aim: to provide security to a third party who isn’t a party to a construction contract but wants the right to bring a claim in the event there is a problem.

Typically:

• the beneficiary of TP Rights or a CW will be the owner of the land, a funder/bank providing development or construction finance, or a purchaser/tenant taking an interest in the land; and

• the warrantor or party granting TP Rights will be responsible for managing, constructing, or designing the works, namely a main contractor, sub-contractor, or professional consultant.

Simply put, TP Rights and CW offer construction security to a beneficiary and increase the risk profile for the warrantor or party granting TR Rights, but how do they work and which option is more common?

Collateral warranties

A CW is a contract. It creates an enforceable relationship between the warrantor and the third party; a direct link between the two. The key term of the CW typically sets out a promise to the beneficiary that the warrantor has observed and will fulfil its obligations in an underlying contract. Hence it is “collateral” to the underlying building contract, sub-contract, or professional appointment. Typically a CW will be signed by the parties and dated on its cover page.

Third party rights

The Contracts (Rights of Third Parties) Act 1999 permits the parties to a contract to grant a non-party (i.e., the third party) the right to enforce terms. To do this effectively, both the contract and the TP Rights being granted requires careful drafting. The relevant rights are usually set out in a schedule to the contract, which notes the terms of the contract that the beneficiary can enforce. To grant the rights, a party then sends a notice identifying the relevant beneficiary and confirming that the rights have been granted.

Key considerations for collateral warranties and third party rights

Some key areas to consider include:

• Consideration [CW only] – in certain circumstances a CW not supported by consideration will be unenforceable and worthless. In others, a CW without consideration may prevent certain remedies, for example an order for specific performance.

• Scope of duty - the party providing the CW/TP Rights should warrant it has complied and will comply with its obligations in the underlying contract, including (where applicable) appropriate standards for workmanship, materials, and the relevant skill and care to be exercised in the design of the works.

• Insurance – there is an undertaking to maintain appropriate insurance on the same basis as set out in the underlying contract.

• Step-in rights - in certain circumstances the beneficiary may want or need to have the right to ‘step-into’ the underlying contract and issue instructions.

• Intellectual property – whether the beneficiary is granted an appropriate license to use and reproduce drawings and other intellectual property.

• Assignment – whether the beneficiary can onward assign the CW/TP Rights to another party in the future (i.e., a future purchaser).

• Limitations of liability – is the CW/TP Rights worth the paper they are written on? For example, is the warrantor entitled to exercise set offs and counterclaims? If so, this may result in damages being limited or reduced if monies are owed to the party providing the CW/TP Rights. In addition, in a claim scenario is there otherwise a right to limit liability under the CW/TP Rights via a cap on liability, exclusion clauses, and/or a net contribution clause?

Which is more common?

The purpose behind CW and TP Rights is the same. They enable a third party, who has or will obtain an interest in a project to claim against those who constructed and/or designed the works, if defects arise which cause it loss. Both can provide effective construction security, if they are comprehensively and properly drafted.

TP Rights are increasingly popular. This is because CW can be administratively more cumbersome, they require an additional ‘standalone’ document to be drafted, signed and dated, whereas TP Rights can be granted via a simple notice, and nothing needs to be signed. That said, we see that typically CW are the preferred option. We suspect the reason for this is the reassurance offered by a physical document; it offers greater comfort.

How we can help

Our team of specialist lawyers draft, negotiate and finalise all tiers of project documents, including construction security in the form of comprehensive CW and TP Rights. Our experience and sector focus results in clear, practical, cost-effective advice on the most important issues.