The Death of Collateral Warranties?

If ever there was a hot topic of debate in property development, it is that of the Collateral Warranty.

It splits all parties of the construction project and causes those involved in the project a substantial amount of extra, and at times felt unjustified, hassle.

We will discuss the rights and wrongs of CWs, what one is, why they are used, and whether the increasing trend of using TPRs is the solution everybody can get behind.

(Please note that I am not a lawyer, and write this article from our own experiences, and from research. Links to that research can be found towards the end of the article).

1. What is a Collateral Warranty?

A Collateral Warranty (CW) is a supporting document to a main, primary build contract, which legally safeguards a third parties’ interest in a construction project.

A CW provides potential legal cover that the main contract does not offer, because in the main contract there is a lack of direct contractual relationship between some of the interested project parties, which can lead to financial exposure for third parties not noted in the primary contract.

In practice a CW requires a construction contractor, sub-contractor or architect to warrant to a third party such as a lender, end buyer or tenant, that they have fulfilled their duties under the construction contract.

2. Why are Collateral Warranties used?

It is possible for a third party with an interest in a construction project to suffer financial losses, as a result of defective work by the construction project team.

The third party tends to be either a lender, end purchaser of the building, or the tenant. Those financial losses can take the form of a loss of funds lent as a result of a reduction in value of the building. They could also take the form of a large repair bill for the end purchaser or much higher service charges for the tenant.

CWs are used because it is very difficult legally for a third party with an interest (lender, end buyer or tenant) to make a claim against construction project firms for defective work without them. This is because typically, third parties are not noted in the primary build contract, and as a result have no direct relationship legally with for example the contractor or sub-contractor.

Now time for some important legal jargon..

CWs came into being after the Courts decided building defect losses were not rectifiable in 'tort', which meant any financial loss could only be chased if there was a direct contractual relationship between the affected parties.

'Privity of Contract' Rules means there is no liability that can arise between parties without the existence of a Collateral Warranty. Therefore CWs were brought into being to give third parties the right contractually to make a claim against any or all of the construction project team, where previously they would otherwise not have been able to do so.

Third parties can make a claim in negligence without a CW, but it’s extremely unlikely to cover most of the losses accrued from defect.

So in essence this is all about financial exposure for the third party to a defective situation, and in the main, current thinking suggests CWs give a funder, buyer or tenant the cover they need.

3. Issues Using Collateral Warranties

The main issue with CWs is time and legal costs for all parties.

CWs in theory should mirror the responsibilities set out in the primary contract, but in practice a number of clauses are hotly debated, and as a result, getting CWs agreed upon can take a lot of time, and a lot of money spent with lawyers.

The main clauses that in a CW are below:

Net Contribution Clause/Limit of liability: a most hotly negotiated clause, the benefits of which very much depend on which side of the table you sit
Duty of Care: reasonable skill and care taken by the Warrantor
Deleterious Materials: the Warrantor will not use any materials that may be harmful
PI cover: potentially the same cover is needed by contractors as is in the main contract
3^rd Party Step-in Provisions/Rights: this allows the third party to take over employment of the Warrantor for the project
Assignment of Warranties: typically 2 at a maximum
No greater liability clause than to the original employer
Further CW requests
Liability Period Clause

Contractors often feel that they are signed up to the hilt already and some third parties can be very difficult to negotiate with.

As a result, the whole process is drawn out, difficult and costly, leaving a negative experience for a number of parties involved.

4. TPRs - the Alternative to CWs

Another option is to invoke the Contracts (Right of Third Parties) Act 1999 (TPRs).

This Act gives the primary contract the ability to give rights to third parties who aren’t signatories in the primary contract, as an alternative to creating multiple separate documents which amount to essentially the same thing but cost a lot of time and money in execution.

TPRs override the Privity of Contract rule founded back in the 1800s, which as you will have noted earlier, meant that unless you were a signatory on a contract, you had no rights under that contract. With this Act, you can now enforce the terms of the contract even if you are not a signatory, provided you have been noted in the contract as a beneficiary.

5. Are TPRs taking over yet?

The current state of play is that CWs are still very much favoured over TPRs, particularly by funders and insurers.

The only real reason for this is that they are more familiar, more in use and therefore feel less risky for a third party to request.

There is some concern that step-in rights for third parties aren’t quite as solid in TPRs as they are in CWs, but from what I can see from legal articles, most lawyers are confident they can draft step-in rights correctly to avoid any issues there.

From a case law point of view, whilst TPRs are relatively untested in the Courts, interestingly, there has been very little in the way of precedent dispute when it comes to CWs either. Two fairly recent cases have made waves though:

Parkwood Leisure Ltd. v Laing O’Rourke Wales and West Limited (2013)

An unexpected verdict was made that has made CWs more vulnerable to protracted negotiation as contractors become more resistant to signing them.

Hurley Palmer Flatt Limited vs. Barclays Bank PLC (2014)

In this instance, Barclays were not given the right to make a claim under the CW.

So there may be a wind of change when it comes to CWs and what both sides of the table expect to be reasonable and fair.

6. Is it the Death of Collateral Warranties?

Collateral warranties are often a serious hassle to sort out. Many construction professionals are not happy signing them, particularly as it is an extra cost to them when they see their obligations are to the direct employer, not the third party.

It has to be recognised however, that third parties effectively allow the project to work too, and have serious exposure if they are not contractually protected against all members of the construction project team.

Finding this middle ground, therefore, is essential for better working relationships in the long term. TPRs appear to be the most convenient and appropriate way forward, given beneficiaries can simply be noted in the primary contract. Legals evidence suggests TPRs should be able to provide the cover everyone needs.

As case law develops, it may be interesting to see if CWs provide the cover they appear to, and whether the trend towards TPRs continue. Many lawyers writing on the subject believe that to be the case.

So is it the death of Collateral Warranties? Not right now, but it is worth investigating the TPR option and keeping abreast of case law developments.

If you’re a developer, have contractual discussions with funders and contracting firms as early as possible to ascertain whether CWs or TPRs can be used. Understand if there will be any issues early with all warrantors so the process can begin, and ideally end, as quickly as humanly possible!