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Collateral Warranties - Explained


This material is intended to be used as a guide only and is not exhaustive. Please seek legal advice if more detailed or specific information is required.

How is a collateral warranty used in practice?

In this example scenario, the Employer engages the Contractor, who in turn engages a Sub-Contractor to undertake a specific element of the works (including design).  The Sub-Contractor provides the Employer with a collateral warranty.  This produces a direct contractual relationship, or link, between the Employer and the Sub-Contractor (otherwise, the Employer is not a party to the separate contractual arrangement between the Contractor and the Sub-Contractor and so has no right of recourse thereunder).

Following completion of the works, defects appear.  Unfortunately for the Employer, the Contractor has by that point become insolvent and has been dissolved.  It is therefore not possible for the Employer to recover from the Contractor any losses arising from the defects.

The defects in question, however, concern works undertaken by the Sub-Contractor.  The Employer is able to make a claim against the Sub-Contractor directly under the terms of the collateral warranty.  Absent the collateral warranty, the Employer may not have been able to recover its losses in relation to the defective works.

What is a collateral warranty?

A collateral warranty is a contract under which a construction professional, contractor or sub-contractor promises to a third party (the "beneficiary") that it has complied with the requirements of its professional appointment, contract or sub-contract.  For example, a sub-contractor may provide a collateral warranty to the project's ultimate employer and / or its funder by which it promises it has completed its works in accordance with its sub-contract. 

A collateral warranty has all the requirements and manifestations of an ordinary contract.  It gives the beneficiary a direct contractual relationship with the party providing it (the "warrantor"), which would otherwise not have existed.  In the scenario above, the Employer is the beneficiary and the Sub-Contractor is the warrantor.  

Why are collateral warranties necessary?

In English law, the rule of privity of contract applies – in short (and unless a contract expressly confers rights on third parties), someone who is not a party to a contract cannot enforce a term of that contract. So, in the example of the relationship between parties provided above, the Employer would not have been able to enforce the terms of the Sub-Contract between the Contractor and the Sub-Contractor. The Employer's contractual rights of recourse would be limited to those against the Contractor under its direct Contract.

A collateral warranty avoids this issue and provides greater security to a beneficiary who has an interest in the works undertaken – by giving it direct contractual relations with additional interested parties.

The principal terms of a collateral warranty contractually oblige the warrantor to fulfil its obligations under the underlying contract or sub-contract, usually including that it will carry out any associated design with reasonable skill and care.  The warrantor's obligation to its immediate contracting party is therefore effectively extended to a separate third party.   

In the above scenario, if the Employer had wanted to recover its losses from the Sub-Contractor in the absence of a collateral warranty, it would have been limited to pursuing a claim in tort (subject to establishing the Sub-Contractor owed it an over-arching duty of care).  The law of tort only allows for the recovery of purely financial losses – "pure economic loss" – in certain limited circumstances (distinct from losses resulting from physical damage).  Such purely financial losses can, however, be recovered where there is a direct contractual relationship, following a breach.  

Collateral warranties therefore allow third parties to recover genuine losses which, in circumstances such as those in the scenario described above, they would otherwise be unable to claim.

Who normally receives a collateral warranty?

By way of certain examples, an employer may require its professional consultants (architects, engineers, etc.) and its Contractor to provide collateral warranties to parties including those funding the design and construction of the works (such as a bank or building society or tenants / end users of the building).

Similarly, an employer may require its Contractor to obtain collateral warranties from its Sub-Contractors or Sub-Consultants in favour of funders and tenants, and / or the employer itself (on the basis it has not directly contracted with those parties).

Collateral warranties are common features of construction projects.

Key clauses in collateral warranties

Collateral warranties commonly include the following express clauses:

  • The warrantor has used reasonable skill, care and diligence.
  • The warrantor has not used or specified harmful / deleterious materials.
  • The warrantor will maintain professional indemnity insurance (often for 12 years from practical completion).
  • The right to assign the benefit of the collateral warranty to a person taking the beneficiary's interest in the project.

The following limitation clauses are also commonly included:

  • No greater duty: the warrantor cannot owe the beneficiary greater duties under the collateral warranty than it would otherwise owe the other contracting party under its appointment.
  • Equivalent rights of defence: the warrantor may use any defence that would have been available under its professional appointment to defend a claim from the beneficiary under the collateral warranty.
  • Time limit: most collateral warranties include a clause limiting the time during which the beneficiary may make a claim against the warrantor.
  • Net contribution clause: limiting liability of the warrantor to that which is "fair and reasonable" or "just and equitable", taking into account the corresponding liability of any other parties.
  • A limit on the type of losses which the beneficiary may recover (for example, exclusion of consequential losses).

Insurance requirements

Insurance policies will commonly provide that cover is conditional upon the warrantor not making itself liable for the following by entering into a collateral warranty:

  • To provide a level of service beyond that which would otherwise be implied at law.
  • To any greater extent, or for a longer period, than it would otherwise have had to the party with whom it originally contracted.
  • Under any financial guarantee, for any contractual penalty or for liquidated damages.

Parties should check the terms of their insurance policies before entering into collateral warranties.

 

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