Collateral Warranties and Third Party Rights: Everything You Need to Know

In construction projects in the UK, two legal mechanisms play significant roles in safeguarding the interests of parties with an interest in those projects but who are not necessarily employing the relevant members of the construction team: collateral warranties and third party rights.

What is a collateral warranty?

In a typical construction project, an employer may employ a contractor under a building contract to carry out building works or appoint a consultant under an appointment to provide services. For each of these relationships, there is a clear contractual link and therefore a potential claim for breach of contract if things go wrong.

But what about third parties with an interest in a project, such as a funder, purchaser or tenant, how can they protect themselves if things go wrong – say if there is a defect in the works – if they are not a party to the relevant construction contracts?  

One solution is a collateral warranty.

Collateral warranties are contracts usually made between a contractor, consultant or subcontractor (the warrantor) in favour of a beneficiary (such as a funder, tenant or purchaser), which give contractual rights to the interested third party that are “collateral” to the relevant underlying contract for a construction project. The warrantor warrants to the beneficiary that it has fulfilled its obligations under the underlying construction contract. The collateral warranty therefore provides a direct contractual link between these parties, offering the beneficiary a right to bring a breach of contract claim in the event of a breach of that underlying construction contract by the warrantor.

For instance, in a commercial development:

• Tenants and purchasers will expect collateral warranties from the team of professional consultants, the contractor and potentially key subcontractors;
• A funder of the project will similarly expect to receive an extensive suite of collateral warranties, which will likely also include step in rights (as discussed below; and
• The employer will want collateral warranties from the contractor’s subcontractors and subconsultants, giving the employer rights of recourse and step in rights into those underlying subcontracts.

Given the scale of some construction projects, there can be a wide range of potential warrantors and a number of potential beneficiaries with an interest in a project who may require collateral warranties. For more complex projects, potential beneficiaries may also include management companies, group companies, joint venture partners or others. 

Why is a collateral warranty required?

Without a direct contractual relationship, a third party may only have a claim in tort. Generally, claims for the purely financial consequences of defects in the works (i.e. a financial loss of rectifying the defect, rather than losses incurred as a result of damage to a person or property) are unlikely to be recoverable in a claim in tort.  This could include many (if not all) of the losses a third party could suffer as a result of a defect in the works.  A collateral warranty gives that third party a direct contractual link with the contractor or consultant, and therefore provides an ability to recover a much broader scope of losses. This makes collateral warranties an important mechanism for third parties to give themselves rights of recourse in the event of defects in the relevant property.

There may also be limited opportunities for a third party to claim under certain statutory rights. For example, for works to dwellings which render the dwelling unfit for habitation, there may be a claim for a breach of the Defective Premises Act 1972. However, that will not cover claims relating to other types of property or where the works are defective but are not so disastrous as to render the dwelling unfit for habitation. 

What is in a collateral warranty agreement?

In its simplest form, a collateral warranty could just include an undertaking from the warrantor to comply with the terms of its underlying contract.  However, they typically also include the following provisions:

Design

Where the warrantor is responsible for any design of the works, it warrants it has used a specified level of skill and care when carrying out its design services.

Prohibited Materials

A prohibition on specifying and/or using materials which are known in the industry to be deleterious.

Copyright

A copyright licence will be granted in favour of the beneficiary, allowing it to reproduce and use the warrantor’s documents and designs in connection with the project.

Insurance

Where the warrantor is responsible for design, it must maintain the specified level of professional indemnity insurance for the duration of its liability, typically 6 or 12 years.

Step-in rights

These allow the beneficiary to step into the underlying construction contract in place of the original employing party.  It is usually a funder stepping in if the employer has defaulted under the finance agreement, or the employer stepping into subcontracts where the building contract has been terminated.

Assignment

The beneficiary is permitted to transfer the benefit of the warranty to another third party, often with restrictions on the number of assignments.

Execution

Collateral warranties will typically be executed as a deed to avoid the legal argument that the contract is unenforceable as a contract due to a lack of consideration and to provide a 12 year liability period for claims for breach of the collateral warranty.

A key feature of a collateral warranty is that it is exactly that: ‘collateral’ to the underlying contract.  Those looking to receive the benefit of a collateral warranty must not simply focus their review on the terms of the collateral warranty but must also establish the terms of the underlying contract. Depending on the drafting of the collateral warranty, limitations on liability included within the underlying contract may well also apply to claims by the beneficiary under the collateral warranty.

What are Third Party Rights?

The Contracts (Rights of Third Parties) Act 1999 was introduced over 20 years ago.  One of the hoped for benefits of the Act was to reduce the administrative burden of procuring collateral warranties.

This Act enables parties to a contract to confer rights on third parties to enforce the terms of that contract, without having to go to the trouble of arranging for the execution of collateral warranties.

For rights to be granted pursuant to this Act:

•  The contract must expressly provide that the third party can enforce a term of the contract; or
• The term must purport to confer a benefit on the third party and the parties to the contract intended that the term should be enforceable by that third party; and
• The third party is expressly identified in the contract by name, as a member of a class or as answering a particular description (but need not be in existence when the contract is entered into).

Usually, the rights to be granted to a third party are specifically identified in the underlying contract.  These rights are conferred on the beneficiary either by naming them as a beneficiary in the underlying contract, or by issuing a notice pursuant to the relevant clause in the underlying contract identifying the relevant beneficiary as a third party entitled to rely on those specific terms of the contract.

Are Third Party Rights a good alternative to Collateral Warranties?

Ultimately, there is little difference between collateral warranties and third party rights in their overall effectiveness.

However, some funders have concerns about the effectiveness of third party rights in granting enforceable step-in rights, as these potentially impose both benefits and burdens on the beneficiary (and the Contracts (Rights of Third Parties) Act 1999 only applies to contractual benefits).  However, ultimately step-in rights should still be enforceable if granted as a third party right, as these grant the right to step-in, and it is only when that right is exercised that the relevant beneficiary becomes subject to the burden of performing the terms of the underlying contract.  

Conclusion

You might naturally assume that third party rights are more prevalent, particularly given the reduced administrative burden – collateral warranties need to be executed (usually as deeds). However, this is far from the reality in practice. Collateral warranties have been, and continue to be, the more popular option.

Partly this is a reflection of people being comfortable with what they know, and what they know will work.

Understanding what terms a beneficiary such as a funder, tenant or purchaser expects to see in a collateral warranty or the third party rights may be critical to the overall success of a development.  If they are not available to be given to the relevant beneficiary or the prescribed terms do not meet the beneficiary’s expectations, this may seriously erode the marketability of the development or could jeopardise the chance of the development securing crucial funding.