Collateral warranties in the construction sector

What is a collateral warranty

A collateral warranty ("CW") creates an enforceable contractual relationship between the warrantor and the third party; a direct link between the two. The key purpose is to set 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.

Who would need a collateral warranty?

Common situations where collateral warranties are important include :-

• Investing in a commercial property - if you are investing in a commercial property, a collateral warranty from the contractor or consultant can protect your investment by ensuring that the building is constructed to the agreed standards. This can be particularly important for properties that are being built or refurbished to specific specifications.

• Financing a construction project - if you are financing a construction project, a collateral warranty from the contractor or consultant can provide you with additional security. This can help to reduce the risk of default and ensure that the project is completed on time and within budget.

• Leasing a commercial property - if you are leasing a commercial property, a collateral warranty from the landlord or developer can protect your business by ensuring that the building is fit for purpose. This can be particularly important for tenants who are occupying a newly built or refurbished property.

It is important to note that collateral warranties are not always necessary, and their use will depend on the specific circumstances of the project. However, they can be a valuable tool for protecting your interests and ensuring that the construction project is completed to a satisfactory standard.

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 third party 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.Collateral Warranties and Third Party Rights

Key considerations for collateral warranties and third party rights

Some key areas to consider include:

• Consideration (collateral warranties only) – in certain circumstances a collateral warranty not supported by consideration will be unenforceable and worthless. In others, a collateral warranty without consideration may prevent certain remedies, for example an order for specific performance.

• Scope of duty - the party providing the comfort 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 – 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 it's rights to another party in the future (i.e., a future purchaser).

• Limitations of liability – warranties and obligations which have been caveated or watered down are a potential problem for the beneficiary. 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 rights. In addition, in a claim scenario is there otherwise a right to limit liability via a cap on liability, exclusion clauses, and/or a net contribution clause?

Collateral warranty or third party rights?

Third party rights are common where saving costs and speed are priorities. Collateral warranties can be administratively more cumbersome and require an additional ‘standalone’ document to be drafted, signed and dated, whereas third party rights can be granted via a simple notice, and nothing needs to be signed.

For a "belt and braces" approach, our clients often favour collateral warranties as the preferred option. 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 collateral warranties and third party rights. Our experience and sector focus results in clear, practical, cost-effective advice on the most important issues.