Collateral warranties in building contracts: the fundamentals

What is a Collateral Warranty?

A collateral warranty is a contract in which a party participating in the works guarantees to a third-party beneficiary that it has met its commitments under its underlying construction contract, subcontract, or professional appointment, known as the underlying contract in this article.

In this post, we will look at the purpose and usual content of a collateral warranty in a construction project. We also briefly discuss an alternate option, as offered by the Contracts (Rights of Third Parties) Act of 1999, which relates to the enforcement of rights in the construction industry.

The Purpose of Collateral Warranty

An employer can hire a contractor to complete building work in a basic construction project. Those two parties often have a formal contractual agreement.

Nevertheless, a variety of stakeholders are always engaged in building projects, including those who are working on the project (contractors and consultants) as well as those who have an interest in the development (funders, buyers, and renters, for instance). Some of those parties will have no direct contractual connection or business relationship of any kind.

In most cases, only one party to a contract has the authority to enforce it. As a result, if a subcontractor violates its subcontract (with the contractor) and the breach has a negative effect on the employer which might also be a funder/purchaser or renter, the employer will be unable to pursue the breach. This causes difficulty for the employer, especially if the major contractor is bankrupt and unable to carry out construction operations.

Moreover, if the employer discovers problems in the subcontractor’s work, in the absence of a collateral warranty, the employer has no practical contractual remedy against any of the parties in the preceding case.

Without that contractual bond, the employer would be forced to rely on a negligence claim. This is not ideal since it would require the employer to prove that the subcontractor owed it a duty of care before its claim could be reviewed. Even in the event of victory, the employer’s liability for carelessness would be restricted.

For the advantage of parties who may not otherwise have any recourse, collateral warranties are used to close the contractual gap and establish a direct contractual relationship.

The step-in rights

Certain collateral warranties may also include “step-in” rights, which essentially provide the beneficiary the ability to take over the underlying contract and issue directives.

If the project’s primary contractor becomes insolvent, the subcontractor is not contractually obligated to follow directions from the employer to carry out construction operations since there is no contractual tie. The employment of a collateral warranty in this case establishes a direct contractual relationship that allows the employer to offer instructions to the subcontractor, ensuring that the latter’s duties are fulfilled.

Important contract considerations

A collateral warranty should represent the responsibilities of the underlying contract as it is essentially a condensed version of it. We expect to see explicit clauses regarding the right to adjudicate in the collateral warranty.

Insurance: The amount and foundation of insurance that the warrantor must keep up all through the risk period.

Principal covenant: The warrantor assures the beneficiary that it has fulfilled and will continue to fulfil its responsibilities under the underlying contract, using a sufficient amount of care and skill in that performance.

Intellectual property license: The right of the beneficiary to duplicate and use the warrantor’s intellectual property.

Step-in rights: Under certain this depends on the conditions of the underlying contract. Having a collateral warranty broadens the possible extent of a provider’s obligation to carry out construction, thus this option should be carefully considered. 
conditions, the beneficiary may replace the directing party in the underlying contract.

Materials: The materials used or specified by the warranting party are appropriate for use and not risky in nature.

Assignment: The option to ‘pass on’ the warranty’s benefit to a different third-party beneficiary.

Do parties have to give collateral warranties?

This depends on the conditions of the underlying contract. Having a collateral warranty broadens the possible extent of a provider’s obligation, thus this option should be carefully considered. 

If necessary, a party can try to reduce the number of warranties it is obliged to offer, or the scope of these warranties, by establishing an overall liability ceiling.

In a collateral warranty, a warranting party (and its insurers) is unlikely to want to go beyond the terms of its underlying contract. Such provisions are common in the collateral warranties we see.

When entering into a collateral warranty, it is essential to get legal assistance to verify that the conditions are appropriate for the intended purpose, whether from the standpoint of a beneficiary or the warranting party.

Rights of third parties

The Contracts (Rights of Third Parties) Act 1999 (the Act) provided a legislative exemption to the idea of privity of contract.

When a third party receives a benefit from a construction contract or an explicit right is granted, the Construction Act permits the third party to enforce the terms of the agreement. The contract should explicitly identify any third-party beneficiary by name or category (such as buyers or renters), with such beneficiaries often included in a rights schedule appended to the underlying agreement. Any such beneficiary will be entitled to any remedy available in an action for breach of contract as if they were an accessory to the contract.

Granting rights under the Construction Act, especially to members of a class, may result in the formation of a large number of third-party beneficiaries, putting the warrantor at risk. While such rights are sometimes provided, contractors and consultants prefer to remove them totally by an explicit provision of the contract and instead depend on collateral warranties.

Summary

Collateral warranties will remain a valuable form of security for construction projects, enabling a beneficiary to avoid the complications of filing a negligence claim in the event that problems occur.

Third-party rights and collateral warranties both have the ability to expand a warranting party’s obligation beyond its immediate employer, which may go above what was first anticipated. While most construction professionals acknowledge that collateral warranties, or third-party rights, are part of a common construction suite of contracts, the scope of additional liabilities to third-party beneficiaries should be factored into the agreed-upon price when negotiating an underlying contract.