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Collateral warranties: an overview

Posted: 04/01/2013

Everyone involved in the construction industry will be aware of the traditional contractual relationships that exist in the basic structure of most construction projects. That is, the employer contracts with the contractor, who in turn contracts with any sub-contractors and/or sub-consultants. This arrangement leaves the employer with no contractual relationship with any of the sub-contractors or sub-consultants.

This is not normally a problem provided the employer appoints a financially robust and competent contractor. In fact, in many instances the employer often prefers to have a contractual relationship with only one party because it creates a single point of responsibility. This means that should problems arise during construction, or, should a defect arise during the liability period, or later, the employer merely has to turn to the contractor to resolve it or to pay up.

However, there may be situations where this lack of contractual relationship with sub-contractors or sub-consultants could be problematic. These typically arise on contractor insolvency, whether during the construction or post completion. Here, if the employer’s only contract is with the contractor, the employer has no contract on which to seek damages and the doctrine of privity of contract prevents him using any agreement between the contractor and sub-contractor or sub-consultant as a means of redress.

Further, the employer is likely to face difficulties in bringing a tortious claim against sub-contractor/sub-consultant because of the restrictions places on the recovery of pure economic loss and because of the difficulty in establishing that a sub-contractor/sub-consultant owes a sufficient duty of care to a distant employer.

In order to address these problems, the employer can require the sub-contractor/sub-consultant to enter into a collateral warranty with them. This creates a direct contractual relationship between the two parties.

Key clauses

Collateral warranties typically follow a standard approach. Some are now standard form documents but many bespoke collateral warranties exist and they need to be read closely to fully understand their effect. The following are examples of the most common clauses. However, more complex projects will likely require tailored collateral warranties.

Consideration : collateral warranties are normally executed as a deed and so do not require consideration. However, sometimes the parties choose to include some nominal consideration just in case the deed is not executed properly. The collateral warranty will then take effect as a contract.

Principal covenant : this is where the sub-contractor/sub-consultant warrants that they have complied with the terms of their sub-contract/appointment. If they have a design responsibility they will also warrant that they have performed this duty with the skill, care and diligence to be expected from a person of the relevant profession.

Employers beware: the principal covenant is only as strong as the sub-contract/appointment. Employers should ensure the sub-contract/appointment includes all key terms and requires the sub-contractor/sub-consultant to exercise a good degree of care. If not, the value of a collateral warranty will inevitably be limited.

Non use of deleterious materials : the sub-contractor/sub-consultant warrants to the employer that he will not use or specify materials that will be deleterious to any part of the works.

Step in rights : these can be very important. They allow the employer to ‘step into the shoes’ of the contractor if the contractor becomes unable to complete the construction – typically through insolvency. In the current economic climate where contractor insolvency is all too common, this clause can be of great importance. However, the sub-contract/appointment should be drafted to make the exercise of these rights optional: for example, the employer may not wish to insist on stepping in as this may not be financially prudent for the employer depending upon the overall financial position of the sub-contract/appointment.

Copyright : many collateral warranties will contain a copyright clause allowing the employer to use any design documents the sub-contractor/sub-consultant prepares. The licence should be royalty free, irrevocable, non-exclusive and include the right to assign.

PI insurance : if the sub-contractor/sub-consultant has design responsibility, the collateral warranty will require that PII is kept in place for the full length of the warranty, typically 12 years if in deed form or six years if in contract form.

Liability period : this will again be 12 years if the collateral warranty is executed as a deed and six if a contract. Employers should seek a liability period equal to the liability period under the building contract.

Assignment : there is usually a restriction on the employer’s ability to assign; often the collateral warranty will provide that two assignments are allowed. Subject to the nature of the works, and whether or not they are likely to be sold often, the warranty may need to expressly provide for assignment more than twice throughout the 12 year period.

Limitations

The sub-contractor/sub-consultant will want to try and limit his liability under the collateral warranty. The most common method of doing this is the use of “no greater duty” and “equivalent rights defence” clauses. These state, respectively, that the sub-contractor/sub-consultant owes no greater duty to the employer than he does to the contractor under the professional sub-contract/appointment and that the sub-contractor/sub-consultant may use any defence available under the sub-contract/appointment when defending any claim under the collateral warranty. In addition, the sub-contractor/sub-consultant will try to limit what can be recovered to make repairs or take remedial action. For example, if consequential trading losses can be claimed, this may be prohibitively expensive.

The sub-contractor/sub-consultant may also try to use a net contribution clause, though the use of these is fairly controversial and usually a matter for negotiation. As often, commercial bargaining power will probably determine who triumphs.

The effect of a net contribution clause is to adjust the default position of joint and several liability. That is, normally, the employer would be able to recover all losses from just one sub-contractor/sub-consultant. The responsibility would then be on that particular sub-contractor/sub-consultant to recover the money he has paid out over and above his ‘fair share’ (i.e.: the proportion of damages attributable to his breach) from the other sub-contractors/sub-consultants by reference to the Civil Liability (Contribution) Act 1978. However, a net contribution clause limits the employers recovery from each sub-contractor/sub-consultant to that which is “just and equitable.” In such circumstance the employer therefore needs to sue all sub-contractors/sub-consultants individually and demonstrate the amount of their contribution. All of this can be significantly harder for an employer than simply demonstrating that damages are due from any one of the sub-contractors/sub-consultants.

Sub-contractors/sub-consultants often push for such net contribution clauses because they push the risk of another sub-contractor’s/sub-consultant’s insolvency and the risk of litigation onto the employer. Employers will wish to resist them for the same reasons.

In the current economic climate when everyone is aware of the increased likelihood of contractor insolvency, the allocation of this risk is often hotly negotiated.

Court’s view

It is perhaps surprising given their prevalence but cases concerning collateral warranties before the English courts are not large in numbers. However, where they have been discussed, it appears the court supports the commercial principle behind collateral warranties; How Engineering Services Ltd v Southern Insulation (Medway) Ltd [2010] and Linklaters Business Services v McAlpine Ltd and others [2010].

Cases concerning net contribution clauses are rarer still. However, the Scottish courts have stated that, even though they seek to limit liability, the clauses do not fall foul of the Unfair Contract Terms Act 1977 ( Langstane Housing Association Ltd v Riverside Construction Aberdeen Ltd & Ors [2009] ScotCS CSOH 52). Whilst this view is not widely supported by legal practitioners, it is by institutions such as RIBA and ACE.

Alternatives

Alternative options to the use of collateral warranties are assignment and third party rights. Neither have proved particularly popular. The trouble with an assignment is that it can only be used once and the Employer may also want to keep part of the benefit. Third party rights are potentially more useful. In fact, they may be more efficient, requiring modified drafting to only one document. However, although use of third party rights has been available since the Contracts (rights of Third Parties) Act 1999 came in to force in November 1999 these have not been widely used and few within the construction industry after familiar with them.

Other requests

Other involved parties may also request collateral warranties. These include any future tenant or purchaser of the property, and freehold owner or any funder of the project.

Arranging and securing fully executed collateral warranties can be hugely time consuming. Many involved in the construction industry are not fans of collateral warranties for this reason. However, those who are putting up the money for projects, whether they be employers or funders, fully recognise the value of securing well drafted collateral warranties and collateral warranties are likely to be around for some time to come.

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Collateral warranties – an update

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Last year, there were two key decisions relating to collateral warranties in Abbey Healthcare (Mill Hill) Ltd-v- Simply Construct (UK) LLP [2022] EWCA Civ 823 and Orchard Plaza Management Co Ltd -v- Balfour Beatty Regional Construction Ltd [2022] EWHC 1490 (TCC). 

In December 2022 it was confirmed that Simply has been granted permission to appeal to the Supreme Court in the case of Abbey Healthcare.

A collateral warranty is a promise by the contractor or a professional consultant (the warrantor) to carry out its obligations under a building contract or professional appointment for the benefit of a third party who has an interest in the construction project such as a purchaser, funder or tenant. 

These two cases cover (i) if a collateral warranty is a ‘construction contract’ under the Housing Grants, Construction and Regeneration Act 1996 (‘the Construction Act’) and (ii) the effect of assignment on the rights under a collateral warranty. 

Is a collateral warranty a construction contract? 

The question of whether a collateral warranty is a construction contract was previously considered in the case of Parkwood Leisure Ltd -v- Laing O’Rourke Wales and West Ltd [2013] EWHC 2665. This question is important because if a collateral warranty is found to be a construction contract, then the beneficiary has certain rights under the Construction Act including the right to adjudicate. The statutory process of adjudication is often a quicker and cheaper way to resolve disputes than litigation or arbitration. 

The decision in Parkwood was clear that not every collateral warranty would be a construction contract as it depended on the precise wording used; if a contractor warranted to positively carry out the construction operations, the collateral warranty would likely be a construction contract but if they only warranted to a previous state of affairs then it pointed towards the collateral warranty not being a construction contract. 

The case of Abbey Healthcare is an example of a beneficiary under a collateral warranty seeking to enforce its rights through adjudication. Abbey was the ultimate tenant and manager of a care home designed and built by Simply. There were some cladding and fire safety defects identified in the building which required remediation. The owner and Abbey commenced separate and successful adjudication proceedings against Simply for the cost of the remediation works. Simply did not pay and argued that the collateral warranty was not a construction contract and so the adjudicator had no jurisdiction. The judge at the enforcement hearing agreed that the collateral warranty was not a construction contract and seemed to rely on the fact that the warranty was given four years after practical completion so Simply were warranting to a past state of affairs and not providing a contract for the carrying out of construction operations. 

The decision of the judge was appealed and the Court of Appeal took a different view. Upholding Parkwood, the majority decided that whether a collateral warranty was a construction contract depended on its wording: whilst the wording in the Abbey collateral warranty differed from the Parkwood collateral warranty it still related to both past and future performance so was a construction contract. The Court of Appeal found that if a collateral warranty was akin to a performance guarantee, then the collateral warranty was not a construction contract. 

The position established by the Court of Appeal could be overturned by the Supreme Court. It remains to be seen if the Supreme Court will row back from the position in Abbey to the earlier more limited position in Parkwood. Until the Supreme Court reaches its decision, any beneficiary under a collateral warranty looking to commence dispute resolution procedure ought to be cautious about pursuing adjudication proceedings. 

Assignment of a Collateral Warranty 

The facts of Orchard Plaza are that a warranty originally given in favour of the funder was then assigned twice, as permitted by the terms of the collateral warranty, to the developer and then finally to the building owner. 

Warranties usually provide a right to assign, albeit usually such assignments are limited in number or limited to a category of beneficiary. It is common to also see what is called a ‘no loss’ clause. This clause is intended to prevent the warrantor arguing that an assignee cannot recover an amount under the collateral warranty because it is an assignee and the assignor has not suffered or incurred any loss or would not have suffered that type of loss. 

In Orchard Plaza, the building owner sought to recover the cost of remedial works from the contractor under the collateral warranty.

The contractor argued that the loss was too remote (ie not reasonably foreseeable as at the date of the underlying contract) as the losses that could have been foreseen by the contractor were those suffered by the funder who originally had the benefit of the collateral warranty (ie the diminution in value of its security). 

The court held that the losses suffered by the building owner were not too remote. It clarified the test for remoteness was whether the kind of loss now claimed was, at the time the contract was made, reasonably contemplated as a serious possibility . The judge decided that it was in the contractor’s reasonable contemplation as a serious possibility that an assignee would incur repair costs because of a breach by the contractor.

Key takeaways 

The Court of Appeal decision in Abbey was significant because many forms of collateral warranties in use were thought likely to be a construction contract. However, the appeal to the Supreme Court means that the right to bring adjudication proceedings in relation to a collateral warranty is still unclear. Until such position is clarified, there is significant risk that using adjudication to resolve a dispute under a collateral warranty could be subject to a successful jurisdictional challenge. 

Beneficiaries who have been assigned the benefit of a collateral warranty will take comfort in the upholding of the no loss provision in Orchard Plaza which is wording commonly used in well-drafted collateral warranties. However, warrantors and their insurers will be more anxious to limit the scope of any assignment provisions and also perhaps, to limit their liability.

Watch this space! We will provide a further update once the Supreme Court has made a decision on Abbey.

• Collateral Warranties

Construction

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Understanding Collateral Warranties

Collateral warranties create a contractual link between the construction team—such as contractors, consultants and subcontractors—and third parties with a stake in the project, such as funders, tenants or purchasers.

As the owner or manager of a construction firm, you know that construction projects, no matter the size or scope, can be significant undertakings fraught with difficulties and setbacks. Not only are you responsible for doing your job effectively and safely, you are responsible for fulfilling your contractual obligations to whoever hired you, whether it was the project’s employer or a contractor.

But your responsibilities can extend even beyond those parties and apply to third parties using what is called a ‘collateral warranty’.

Collateral warranties create a contractual link between the construction team—such as contractors, consultants and subcontractors—and third parties with a stake in the project, such as funders, tenants or purchasers. That way, the third party has a direct contractual relationship through the collateral warranty to pursue legal action against the construction team in the case of negligence.

Despite the value and potential drawbacks of a collateral warranty, some firms may not be familiar with the document. Fortunately, this overview explains the potential benefits and structure in a clear and straightforward manner.

Why a Collateral Warranty is Necessary

Whilst neither your firm nor a third party are obligated to enter into a collateral warranty, third parties opt for them for three main reasons:

1.       The contract between the employer and the primary contractor does not allow third parties to be written in after it has been finalised.

2.       It provides third parties with the ability to file a claim against members of the construction team for the quality of work that they contributed.

3.       It may provide third parties with step-in rights, which allows them to ‘step in’ to the shoes of the project’s employer. Step-in rights can be used to ensure that a project is completed if, for example, the project’s employer becomes insolvent—when this occurs a third party such as the funder or purchaser can ‘step in’ and take the place of the employer to see the project to completion.

Key Clauses in a Collateral Warranty

Collateral warranties typically contain the following provisions:

·         Principal covenant ensures that warrantors (the contractor, subcontractor or other members of the construction team) will perform their duties with reasonable skill and care and fulfil their obligations in the main contract.

·         Insurance policy explains the required level of professional indemnity insurance that warrantors must hold, which usually matches the insurance requirement in the main contract.

·         Deleterious material clause states that warrantors will not use any deleterious materials, or materials that are harmful to people or the building itself, during the project.

·         Copyright licence allows third parties to copy and use design documents created by the warrantors.

·         Assignment clause specifies how many times the collateral warranty’s benefits may be assigned (for example, to the property’s next purchaser).

·         Liability limitation encompasses a range of clauses that help limit the warrantors’ liability. Such clauses include a ‘no greater liability’ clause, stipulating that warrantors take on no greater liability to the warranty’s recipient than they did under the original contract.

·         Time period states how long the collateral warranty is in effect (usually 12 years).

This list is not exhaustive and collateral warranties are typically bespoke documents that are created for particular projects. However, the Joint Contracts Tribunal does provide collateral warranties that you or your employer can use or amend for your purposes.  Click here  for more information.

How a Collateral Warranty May Affect Your Professional Indemnity (PI) Insurance

A collateral warranty may affect your PI insurance policy in the following ways:

·         A collateral warranty will increase your potential liability by expanding the range of potential parties who may bring a claim against you.

·         A collateral warranty may require you to extend the length of your PI insurance, which in turn may increase your PI premium.

·         A collateral warranty may require you to increase the value of your PI insurance to cover the warranty in its entirety.

If you plan to enter into a collateral warranty, be sure to verify whether the agreement will require you to adjust your PI insurance. Alert Willis IRM if you enter into a collateral warranty and we can help ensure your insurance is adequate to protect your business.      

Drawbacks of Using a Collateral Warranty

Despite the potential benefits that a collateral warranty may provide, there are some inherent difficulties with the document. Whilst you may not experience all of these complications, the following are the most prevalent:

·         Depending on the size of the project, the process of using a collateral warranty can be slow and expensive, as it requires several parties to negotiate, prepare, circulate and sign the document.

·         The employer may pressure you to accept a collateral warranty that imposes extra obligations on your firm beyond the original contract.

·         The employer may reject your ability to include clauses that limit your liability, such as the ‘no greater liability’ clause.

Entering into a Collateral Warranty

Before you enter into a collateral warranty, you should review the following beneficial guidance:

·         What you should do upon receiving a collateral warranty. After you receive a collateral warranty, you should verify that it does not infringe upon the terms of your PI insurance. Contact Willis IRM in order to verify that your PI insurance is appropriate and that you are properly covered according to your liability under the collateral warranty.

·         What you should look out for when agreeing to a collateral warranty. Ensure you know the following four pieces of crucial information:

1.       An outline of the amount of responsibility expected of you

2.       Whether you have the opportunity to effectively limit your liability

3.       The date for when the liability will expire

4.       The number of third parties that are able to bring a claim

·         Guidance on how to enter into a collateral warranty. Whilst you are not legally obligated to enter into a collateral warranty, you may be put under commercial pressure to do so. If the terms of your contract state that you are to enter into a warranty, you should be aware of how it will affect your insurance and liability.

Build With Confidence

Construction projects can be complex undertakings with multiple moving parts that must be regularly addressed and monitored. Neglecting to inspect all contracts and attendant collateral warranties for extra liability could be disastrous to your firm—exposing you to undue liability and opening you to possible claims from third parties.

Build with confidence and limit your liability by understanding how to use collateral warranties to your advantage. For more information, contact the insurance professionals at Willis IRM today

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• 07 November 2017
• Construction

Collateral Warranties: What to look for?

Collateral warranties are a key feature of the construction industry, and they enable beneficiaries such as funders, tenants or purchasers of a development to have a contractual link with the project team. whilst it is possible to utilise the third party rights act, this route is limited, as seen in the case of hurley palmer flatt limited v barclays bank plc [2014] and you can read our analysis here ..

Given the importance of collateral warranties, the focus of this article will be to provide a general overview on some of the clauses and limitations that appear in collateral warranties.

Clauses and their effects?

There are a range of clauses that are typical to collateral warranties, but the key ones highlighted here relate to deleterious materials, professional indemnity insurance, copyright, assignment and step-in rights.

• Deleterious materials – Such a clause will usually contain an obligation to confirm that no deleterious materials which may be damaging to health or the environment will be specified or used in the project. However, it is limited to the level of skill care and diligence required by the professional appointment or building contract.
• Professional indemnity insurance – This clause requires professional indemnity insurance, with reference to asbestos and contamination exclusions under the policy, to be maintained for a specific period of time (usually 12 years from practical completion of the project).
• Copyright licence and use of information – These clauses are commonly included to allow a third-party beneficiary to use design information generated by the project, but only in connection with the project. Copyright should be retained by the warrantor.
• Assignment – It is common for beneficiaries to be afforded the right to assign the benefit of the collateral warranty to a third party. This right to assign may be limited in number to restrict the number of assignments the beneficiary is entitled to.
• Step-in rights – These are often included to give the beneficiary (usually a funder) the right to take the place of an employer under the main contract if the employer were ever to commit a serious and un-remedied breach, that would otherwise enable the warrantor to terminate their contract with them. In practical terms, this right is beneficial to both the warrantor and the beneficiary as the project may continue to completion even though the employer has committed the serious breach, and so allowing the project value to be realised.

Stephen James

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Limitations for the party granting the collateral warranty

A wide range of limitation and exclusion of liability clauses will be relevant when a collateral warranty is being negotiated. These include:

• No greater liability – If this clause is included, then it confirms that the warrantor will take on no greater risk under a collateral warranty than under the main contract; meaning that they cannot be made to pay more than they would be liable for under the original contract.
• Equivalent rights of defence – Such a clause stipulates that all the same rights of defence under the main contract will be available to the warrantor under the collateral warranty, ensuring that the contracts are back-to-back.
• Limitation to the claim period of a beneficiary – This clause limits the period during which a claim can be made by a beneficiary against the warrantor; this is often 12 years from practical completion.
• Net contribution – This clause apportions liability between each party liable for the same loss or damage and are used to limit the warrantor’s liability to a fair and reasonable amount.

These limitations all should take into account the parties’ bargaining positions and the nature/value of the project.

In considering these clauses and limitations, the essence of a collateral warranty is that it is ‘collateral’ to the professional appointment or building contract. In practice, collateral warranties may be harder to enforce if the equivalent provisions in the underlying contract are not the same.

Therefore, collateral warranties are only as good as the underlying contract, and so special attention must be paid to ensuring that they are fully ‘back-to-back’ with the underlying contract.

About this article

• Subject Collateral Warranties: What to look for?
• Author Stephen James
• Expertise Construction
• Published 07 November 2017

Disclaimer This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to the full General Notices on our website.

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Sarah Wales-Canning

Assignment provisions are often found in construction contracts, including collateral warranties, and they are used to transfer the benefit of a construction contract from one party to another. When providing development and real estate finance, there are a number of issues lenders need to consider in relation to assignment of construction documents as part of their overall security package.

Benefits for a lender

If the benefit of a construction contract is assigned from a borrower to a lender, the obligations of the contractor or consultant are then owed to the lender and the lender can demand performance of the contractor's or consultant's obligations under those contracts. Assignment also allows the lender to enforce the terms of the relevant contract or pursue a claim against the contractor or consultant where they are in breach.

The lender may have the benefit of collateral warranties which creates a contractual link between the lender and the contractor or consultants. However, these will not usually enable the lender to enforce the terms of the underlying contract unless the lender formally "steps-in" and uses express rights and meets express conditions in the collateral warranties.

Assignment therefore makes enforcement more streamlined.

Legal assignment versus equitable assignment

The law recognises two different types of assignment – legal or equitable.

A legal assignment must be in writing, absolute and notice must be given to the other parties. An equitable assignment is not subject to the same requirements.

The main difference between the two types of assignment is that an equitable assignee (who benefits from the assignment) must join the assignor (the person who assigns their right) in any action against the contractor or consultant. A legal assignee can bring an action themselves.

In practice, equitable assignment is often preferred by lenders as it can be achieved in the debenture or facility agreement without the need for a separate deed of assignment and notices to the contractor or consultant. It also allows the borrower to retain the benefit of the construction documents so that they can continue to have the right to enforce the terms.

Charge versus security

Where a lender takes a charge over a contract, this gives the lender a right over the benefit of the contract instead of assigning it the benefit of the contract.

If the benefit of a contract is assigned by way of security, the benefit is transferred to the lender. On redemption of the loan, the lender will need to re-assign the benefit of the contract back to the borrower. This can be problematic where there is a limit on the number of permitted assignments and no carve out for assignment in this manner.

Further considerations

Where a contract contains an express assignment provision, common issues include:

• Assignment being restricted to absolute legal assignment, which means that equitable assignments are not permitted, including granting a charge
• Limits on the number of permitted assignments, which could have been wholly or partly used up already
• No carve out for assignments by way of security and reassignment on redemption which means that both assignments will count towards the permitted number, and will often use them up entirely.

It's important for lenders to understand what assignment options are available for construction contracts and assess whether they allow for sufficient security.

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20 September 2019

What is a Deed of Collateral Warranty?

In a construction context, a deed of collateral warranty is a deed signed by a subcontractor that contains warranties and other obligations in favour of the ultimate principal on the project.

What does a Collateral Warranty Deed look like?

Usually a collateral warranty deed is issued by the principal under the head contract, as an attachment to the head contract. They are almost always prepared in the form of a deed.

Sometimes they are given a different name, such as 'Subcontractor Warranty Deed' or 'Subcontractor Side Deed'.  Despite their different titles, the purpose of these documents is usually much the same. 

Why are Collateral Warranty Deeds used?

The purpose of a collateral warranty deed is to ensure the ultimate principal on the project can sue a subcontractor, should the need arise. Most of the time, the warranties contained in these deeds are intended to protect the principal against the risk of defects.

Without a collateral warranty deed, the principal may not be able to bring claims against subcontractors. Instead, the principal's sole right of recourse is likely to be against the head contractor (being the only party with whom the principal has a contract).

If the head contractor is unable to satisfy a claim brought by the principal - for example, if the head contractor is insolvent - this could leave the principal in a position where it has no effective right of recourse at all.

The purpose of a collateral warranty is to bridge the gap between subcontractor and principal, so that if the principal cannot pursue (or does not wish to pursue) the head contractor for some reason, it can bring its claim directly against the subcontractor.

Who can a Collateral Warranty Deed benefit?

The most common form of collateral warranty deed is the type issued by a principal, which is required to be signed by a subcontractor. The provision of Collateral Warranty Deeds is often expressed to be a condition precedent of achieving practical completion under the head contract. 

However collateral warranty deeds can be used, and often are used, for a variety of other purposes. They can be used in virtually any circumstance where a party wishes to create a right of action against someone with whom it would not otherwise have any contractual link. 

For example:

• a head contractor may require a subcontractor to provide collateral warranty deeds signed by subcontractors further down the contracting chain;
• a financier may require its client, the principal, to provide a collateral warranty deed signed by the head contractor;
• a landlord may require its tenant, to provide a collateral warranty deed signed by the head contractor for work performed in the landlord's building.

When should a Collateral Warranty Deed be collected?

Where a contract requires a collateral warranty deed to be provided, it will normally be required:

• around the time of contract award or subcontract award (and sometimes these deeds are referred to as 'Deeds of Covenant');
• around the time of practical completion, and their provision is often expressed to be a condition to achieving practical completion; or
• at both of the times mentioned above.

Where the purpose of the deed is to protect someone against the risk of defects, it is unlikely to make much practical difference if the deed is required to be provided at the start of the project or at the end, provided the deed is appropriately drafted.

Some collateral warranty deeds will contain warranties or obligations that relate to the manner in which the work is to be performed. Where that type of warranty is required, the deed should obviously be sought at the beginning of the project.  There would be little point in seeking that type of warranty after practical completion.

What does a Collateral Warranty Deed contain?

Below are some common terms that you might find in a typical collateral warranty deed.

Performance Warranties

Most collateral warranty deeds contain:

• a warranty that the warrantor has performed, or will perform, its obligations under the underlying contract; and
• warranties in relation to the goods or services it has supplied, or will supply, for the project. These warranties are typically expressed to operate for a period of time, to give the beneficiary of the warranty comfort about the quality of the goods or services in question.

These warranties will be expressed to be in favour of the beneficiary named in the warranty deed, typically being the principal or other upstream party.

The warranties in a collateral warranty deed are often supported or supplemented by indemnities. (If you are a contractor, you can read more about indemnities in construction contracts here .)

The rights contained in a collateral warranty deed are typically expressed to be assignable by the person having the benefit of the warranty.  This ensures that, where the relevant building or land is sold, the seller can pass on the benefit of the warranties to the new owner.

What to look for in a Collateral Warranty Deed

If you are a principal or other party seeking to put in place a collateral warranty deed, this is an area where legal advice should be sought.

Although most collateral warranty deeds share common features, there is no commonly accepted standard form. You will also need to ensure that your head contract contains provisions to ensure these deeds are collected and provided to you before the end of the project.

If you are a contractor reviewing a collateral warranty deed, the main thing to consider is whether the terms of the deed will increase your risk profile on the project. Two initial questions are:

• Does the deed contain obligations or warranties that are more onerous than those contained in your main contract?
• Will you be exposing yourself to greater liability by making promises, or giving indemnities, to the party(s) named in the warranty deed?

You may find the drafting of these deeds somewhat technical, and you may find it difficult to establish whether the terms pose any material risk. If you are unsure, or you find yourself guessing, that may be a sign that it's time to speak to a construction lawyer. (You can read more about working with construction lawyers here .)

About the Author

Morgan McIntosh | Senior Associate

Morgan is a specialist construction lawyer in Sydney who helps companies navigate through large or unusual projects and streamline their contracting processes through simplified contracts.

[email protected] | (02) 9229 2901

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A Guide to Collateral Warranties on Construction Projects

Published 12 January 2022  |  Myerson Solicitors

Blogs || Construction || 8 minutes reading time

In this article, we consider collateral warranties, which are often used on construction projects, and we explain what they are, why they may be required, some alternatives to collateral warranties (such as third-party rights) and which parties are likely to give and receive collateral warranties.

What are Collateral Warranties?

In UK law, there is a doctrine of privity of contract which prevents a person who is not a party to a contract from enforcing a term of that contract. The general rule is very simple: only the parties to a contract may sue on it or be sued for breach of its terms. In the context of construction projects, this means that only the employer is able to enforce the terms of the building contract or any professional appointments, for example, that of an architect or structural engineer.

However, other parties often have an interest in the works either during construction or once the works are completed, such as funders, lenders, purchasers, and tenants. It is also often the case that defects may not arise or be discovered until some time after the works have been completed, with the party that is actually affected by the defect being the person in occupation, i.e. the purchaser or tenant.  

If those third parties suffer a loss, such as lost income, or they have to incur the costs of rectifying the defect, then they will be the persons who will need the ability to pursue a claim against the contractor or the professional consultant responsible for the defect. However, since they are not a party to the building contract or professional appointment, they will be unable to pursue a contractual claim under the building contract or professional appointment.  

An alternative to a contractual claim is to bring a claim in tort as a result of negligence. However, in UK law, there are legal limitations on the ability to recover what lawyers refer to as “pure economic loss” in claims in tort, which causes a particular issue in the context of construction claims.  

Economic loss is effectively a financial loss as opposed to damage to a person or property. 

For example, if the defect causes damage to other property or personal injury, then that damage would be recoverable in tort, but the problem is that the costs to rectify the defect itself are purely economic and are unlikely to be recoverable in tort. So if a property has been constructed improperly and it injures an occupier, a claim for the losses arising from the personal injury would be recoverable in tort (subject to satisfying the other requirements for a claim in tort), but the costs to rectify the defect would most likely not.

Since there is unlikely to be an ability to bring a claim for the costs to rectify the defect in either contract or tort, the interested third parties need another route, and this is where collateral warranties come in. A collateral warranty creates a contractual link between the third party and the contractor or professional consultant.

A collateral warranty is a contract that sits alongside the underlying contract, such as a building contract or consultant appointment, and grants rights to a third party which can be sued upon. 

A collateral warranty is much shorter than the underlying contract because, to a large extent, it relies upon the terms of the underlying contract. In the collateral warranty, the warrantor will warrant to the third party that it has performed its duties and obligations in accordance with the underlying contract. Therefore, if there is a breach of the underlying contract, that will usually trigger a collateral warranty breach. This is a key point to note in relation to a claim under a collateral warranty. It is effectively a claim for a breach of the promise to comply with the underlying contract.  

The limitations regarding “pure economic loss” mentioned previously do not apply to contractual claims, so the costs of rectifying the defect would be recoverable as well as any other pure economic losses such as lost income or profit. 

In order to obtain collateral warranties, the underlying building contract, appointment or sub-contract will need to expressly provide that the contractor, consultant or sub-contractor is required to provide collateral warranties to third parties. Collateral warranties may be provided to third parties during the course of the works or after completion.

When a collateral warranty is provided, it is essential to ensure that it has been signed correctly by the right people. Any failure to execute a warranty correctly can affect its validity.

There are some standard forms of collateral warranty, such as those published by JCT and the CIC, but these forms contain several limits on the liability of the person providing the warranty, and they may not be acceptable to the third party. In practice, most employers will usually use their own bespoke forms of collateral warranty.

Are there any alternatives to collateral warranties?

There are some alternative ways to grant rights to the interested third rights in construction projects.  

The Contracts (Rights of Third Parties) Act 1999 alters the doctrine of privity of contract and, in certain circumstances, allows a third party to enforce the terms of a contract made between other parties for its benefit.  

The granting of rights in this way is a viable alternative, but the underlying contract often excludes third party rights, and many parties still prefer to receive collateral warranties. If third party rights under The Contracts (Rights of Third Parties) Act 1999 are to be adopted, then this has to be dealt with in the underlying contracts at the outset, which is still a fairly rare occurrence.

Another way to grant rights to third parties is by assigning the rights under the original contract, but this is not always appropriate. For example, an employer could assign its rights under the building contract to an incoming tenant. 

However, if the employer still owns the completed building, it will need to retain its rights in case it needs to claim itself in respect of defects in the works. 

Another alternative to a collateral warranty can be a letter of reliance. This is a letter giving a third party the right to rely upon a report prepared by a professional consultant, typically used in site investigations, ground condition reports, and surveys. 

These are not usually used where there is an underlying contract or appointment; there is an ongoing role in relation to the performance of services and duties or where it relates to design or construction. 

Who should give a collateral warranty?

Parties that regularly provide collateral warranties to third parties on a construction project include main contractors, consultants (usually those with responsibility for design including the architect and engineers and also those with no design responsibility, e.g. project manager) and sub-contractors (although sub-contractors with responsibility for design are more likely to provide them than non-designers).

Who should receive a collateral warranty?

Parties that frequently require collateral warranties from the construction and design team on a construction project include:

Funders -   banks and other lenders funding construction works who are taking a charge over the property, rather than purchasing it, will require collateral warranties. This protects the funder if the borrower defaults under the finance agreement and the funder has to recover its loss by selling the development. The funder will require the ability to make a claim against the construction and design team if there are defects in the works that reduce the value. The funder will also require step-in rights in its collateral warranties, allowing it to step into the employer’s role in the underlying building contract and procure the completion of the development. 

Purchasers - a party that buys the development (either before or during construction as a ‘forward purchaser’ or after completion) will acquire a long-term interest in the building, even if they do not intend to occupy the building themselves, they may suffer a loss as a result of defects in the works. A purchaser will therefore require rights against the construction and design team so that they can claim against them in the event of defects arising.

Tenants -   a tenant will often have a lease on a fully insuring and repairing basis. They will therefore require collateral warranties to allow them to claim against the construction and design team in the event they need to pay for the rectification of a defect. On projects where there are a number of tenants, it is usual for only those taking a lease of a substantial part of the development to receive a warranty. The obligation on the construction and design team to provide warranties to tenants is often limited to the first tenants of the property.

Employers -   the employer will not require a collateral warranty from the main contractor and the consultants as it has a direct contractual link to them already by way of the building contract and professional consultant appointments. However, the employer is likely to require collateral warranties from sub-contractors engaged by the contractor. Otherwise, it cannot bring a claim against them, particularly if the main contractor becomes insolvent. In addition, where the project is procured using the design and build route, it is usual practice for the appointments of the design consultants to be novated to the contractor. As a result, the employer loses its direct contractual link to the design consultants and so will require a collateral warranty back from the novated consultants to maintain its rights against them.

There are also other parties who might also require a collateral warranty on some projects where they have an interest in the works, such as a local authority or freeholder. On large multi-let developments, the management company might require a collateral warranty, or if a tenant of an existing property is carrying out the works, the landlord may require a collateral warranty. 

Here to help

At Myerson, our Construction Team can offer advice on all aspects of contentious and non-contentious matters. We regularly advise and draft collateral warranties for construction projects on behalf of employers or third parties. For more information on the range of legal services we provide, please contact our Construction Team below.

Contact Myerson Solicitors

Complete the form below, or alternatively, you can call Myerson Solicitors on:

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Assignment of a collateral warranty

Published by a lexisnexis construction expert.

This Practice Note focuses on the assignment of collateral warranties (see Practice Note: What are collateral warranties?). For more detailed guidance on assignment in general, see Practice Notes: Assignment in construction contracts and Legal and equitable assignment in construction contracts. Although this Practice Note refers to collateral warranties, the principles also apply where third party rights are used as an alternative to collateral warranties, see: Contracts (Rights of Third Parties) Act 1999 in construction—overview.

Assignment provisions in collateral warranties

The general rule is that if a contract is silent on the issue of assignment, this means that the benefit of the contract can be assigned without limit or without requiring consent (as permitted by law under section 136(1) of the Law of Property Act 1925 (LPA 1925))—there is no requirement to obtain the consent of the obligor to any proposed assignment. See Practice Note: Restrictions on the assignment of rights in construction contracts.

Most construction contracts contain express assignment clauses to clarify the rights of each of the parties in respect of assignment and this is also usually the

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Assignment definition, what does assignment mean.

An assignment is 'an immediate transfer of an existing proprietary right, vested or contingent from one party to another'. Assignments can occur by consent or by operation of law.

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What are collateral warranties?

Published by a lexisnexis construction expert.

This Practice Note looks at what a collateral warranty is, which parties will want collateral warranties on a construction project and why. It considers the usual beneficiaries of collateral warranties and the rights that they acquire against the warrantor concerning the building contract , consultant’s appointment or sub-contract.

It is a general principle of contract law that only a person who is a party to a contract can bring a claim under that contract. This is known as the doctrine of privity of contract. In the absence of any other direct contractual relationship, a contractor or a consultant will not normally owe a contractual duty of care to any person other than its direct client. (Note that the doctrine of privity of contract has, however, been altered by the Contracts (Rights of Third Parties) Act 1999 which, in certain circumstances, permits a party to enforce the terms of a contract made between others for its benefit. For more information see Practice Note: The Contracts (Rights of Third Parties) Act 1999 in construction contracts).

Many of the defects that arise

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Key definition:

Collateral definition, what does collateral mean.

Assets put up as security to protect a tender in case the borrower defaults.

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