Guide to the use of collateral warranties in construction and engineering

In this article, our experienced construction solicitors explain everything you need to know about collateral warranties, covering their purpose, length, who provides them, who benefits from them, and the common clauses used.

What is the purpose of a collateral warranty? 

There are many parties involved in the delivery of a construction and engineering project and the contractual relationships between them are complex. Those parties include:

• employers/developers;
• main contractors;
• construction professionals and consultants;
• sub-contractors; and 
• suppliers.  

Then there are those who may not be a party to the various contracts set up for the delivery of the project, but benefit from the construction project itself. These parties include:

•  employers/developers (in part);
• funders and lenders; and
• end users such as purchasers, landlords and tenants (together referred to as beneficiaries). 

These third party beneficiaries are ultimately affected by any issues arising in or after the delivery of the project, most notably defects in the works. Collateral warranties play an important role in providing these third parties with contractual rights to make a claim that would otherwise not be available to them. To put it simply, without collateral warranties, only parties to a contract can enforce its terms, meaning that if a third party (such as a tenant or purchaser of a property) wants to make a claim against the contractor for defects in the construction work, they cannot do so as they were not party to the original contract. Collateral warranties provide a solution to this problem by creating a separate contract between the third party and the contractor, allowing the third party to enforce the terms of the original contract. This means that if defects arise, the third party can claim against the contractor, even though they were not a direct party to the original contract.

Collateral warranties serve to protect third parties with an interest in the construction project and help to ensure that the work is completed to a satisfactory standard.

Who provides a collateral warranty? 

A collateral warranty is usually provided by a party (the warrantor) based on a requirement in the underlying contract. 

It is common for a collateral warranty to be provided as a warrantor by the construction professionals and consultants, main contractors and sub-contractors with a material design responsibility. Although a collateral warranty can be provided by others involved in the delivery of the project. 

A project may involve the provision of a separate collateral warranty by a warrantor to several parties. 

What are the common clauses in a collateral warranty? 

Common clauses include: 

• ​a warranty that the warrantor will comply or has complied with the terms of the underlying contract (the building and engineering contract, the form of appointment of the construction professional/consultant or the sub-contract, as appropriate); 
• a warranty that the warrantor has exercised or will exercise reasonable skill and care in the provision of its services, including design and management services as appropriate; 
• an obligation to maintain suitable professional indemnity insurance and to provide evidence of that insurance (see note below); 
• the granting to the beneficiary of a licence to copy and use material produced by the warrantor on the project; 
• a limitation on the ability of the party with the benefit of the collateral warranty (the beneficiary) to assign the benefit of the collateral warranty (usually on a set number of occasions and/or to associated parties);  
• terms that the warrantor will have no greater liability and will have equivalent rights of defence to those in the underlying contract;  
• a limitation on the liability of the warrantor to the beneficiary; 
• a time limit after which a claim cannot be commenced against the warrantor; and  
• (in the case of funders) the ability to step into the underlying contract.  

A note on professional indemnity insurance (PII):

When it comes PII policies, there are two types of coverage:

1. 'Each and every claim made' policies provide coverage for each individual claim that is made against the policy during the policy period. This means that the policy limit applies to each claim separately, regardless of how many claims are made during the policy period.
2. In the aggregate' policies provide coverage for all claims that are made against the policy during the policy period, up to the policy limit. This means that the policy limit applies to the total amount of all claims made during the policy period.

The main difference between the two types of policies is the way that they handle multiple claims during the same policy period. If a professional concern has made previous claims against its PII policy within the same claims year, an 'each and every claim made' policy can be more beneficial as it provides coverage for each individual claim made, up to the policy limit. In comparison, under an 'in the aggregate' policy, the policy limit applies to the total amount of all claims made during the policy period. This means that if multiple claims are made during the same policy period, the policy limit may be exhausted, leaving the professional concern with no further coverage for any subsequent claims.

It is important to consider the type of insurance cover the warrantor has, its potential exposure to claims and claims history in the same year (if the policy held is aggregate), because this can have a considerable impact on what can be recovered in the event of a claim.

Should I use a standard form of collateral warranty? 

The quality of the protection provided by a collateral warranty depends on the terms of the underlying contract, and the terms of that underlying contract will have to be carefully considered to ensure that it provides the required security for the beneficiary. 

Whilst there are some standard form collateral warranties available, it is usual for a bespoke collateral warranty to be included in the underlying contract. 

Given that a beneficiary should consider the terms of the underlying contract, a beneficiary should seek a collateral warranty drafted with the requirements of the project in mind. 

How much does a collateral warranty cost? 

A collateral warranty on its own is not a long document and is not usually expensive or time-consuming to prepare, review and negotiate.  

To assess the protection provided by a collateral warranty, the underlying contract must be considered, and that exercise adds some expense. 

The costs of a collateral warranty are not large when compared to the protection that a collateral warranty can provide. 

How long does a collateral warranty last? 

The period of liability under a collateral warranty is usually the same as that under the underlying contract, whether by reference to the express terms of the collateral warranty or by the warrantor having no greater liability (which would include any provision as to the time within which a claim must be commenced) than that under the underlying contract. Most collateral warranties are provided in relation to an underlying contract which has been executed as a deed and it is usual for a collateral warranty itself to be executed as a deed. 

Limitation periods:

If the collateral warranty is executed as a deed, the relevant limitation period runs for 12 years, but if it is signed as a contract then it is 6 years

When does the limitation period begin?

For most collateral warranties, the limitation period commences from the date of Practical Completion of the Works (PC) rather than from the date on which the actual breach of the underlying contract occurred. This is preferrable, as it can be extremely difficult to pinpoint the exact date the breach occurred, and often leads to costly initial satellite litigation to determine the start date in the first instance, before the claim itself can be considered. It is common practice to use the date of PC (which is a defined date) as being the commencement of the limitation period, in order to avoid an argument as to when it commences.

Can collateral warranties be amended or transferred?

Amendments

If all parties agree to it then amending the collateral warranty is straightforward. In practice, warrantors tend to resist making amendments to the agreed form of collateral warranty. If such resistance is met, and there are no other feasible solutions, beneficiaries may need to settle for a recital to the collateral warranty agreement stating the updated position.

A good example is where the warrantor changes its status or entity - for instance, converting from a partnership to an LLP. A beneficiary will rightly be concerned whether the new structure has assumed liability for the obligations under the collateral warranty. Ideally, the warrantor should change its name and update the relevant execution procedures on the collateral warranty document accordingly, but beneficiaries often find themselves with just recitals recording the same.

Transfer

The general rule is that where a contract is silent on the topic, the benefit of the contract can be assigned without limit or consent. It is standard practice that the collateral warranty contract expressly deals with the issue of assignment or transfer of rights. The warranting party will seek to limit the number of assignments possible to control the number of third parties they are liable to. Normally, two assignments are allowed without restriction, while additional assignments require the warrantor's consent.

It is important to note that only the benefit under a contract can be assigned, not obligations. This means that contractual rights, such as the right to receive payment, may be assigned to another party but the obligation for the original contracting party to perform works or services cannot. To assign all the benefits and burdens of a contract, the original contracting parties will need to enter into what is known as a novation agreement with the new party.

Some beneficiaries, like funders, may request 'step in’ rights, allowing them to assume the role of the employer in specific situations, such as insolvency. The collateral warranty should specifically include details of these provisions including notification processes and circumstances triggering the step-in rights.

Are there any alternatives to collateral warranties?

Contracts (Rights of Third Parties) Act 1999

The Contracts (Rights of Third Parties) Act 1999 changes the concept of privity of contract by allowing a third party to enforce a contract made for its benefit in certain situations.

Adoption of third-party rights under the Act requires the original contract to explicitly confirm that a third party may enforce its rights under it. If this is the preferred route, it is important that the original contract contains several key items and provisions, referring to the clauses in the underlying contract that the third party may enforce, or a standalone schedule. Although a viable and sometimes less expensive alternative to collateral warranty contracts, in practice many building contracts (and contracts in general) seek to limit exposure and exclude third party rights.

Assigning rights from the original contract

The employer of the professional consultants or contractors could technically assign their building contract rights to the purchaser or tenant of the end development. In practice this may be unsuitable especially if the employer still owns the building – by assigning their rights to another party the employer will then have lost its ability to address any discovered defects in the works.

Structural insurance policy

Structural insurance, also known as latent defects insurance, safeguards investors, homeowners, occupants, and mortgagees against structural issues post-construction, typically spanning 10 to 12 years after completion. Insurance provides no fault protection, in that there is no need to prove negligence on the part of liable parties like contractors or architects. This means potentially avoiding a lengthy and costly court battle with defects claims. The insurer covers costs regardless of the solvency or insurance status of the contractor. Like with any insurance, the policy may contain exclusions and limits that could affect claims. Another key drawback with latent defects insurance is that it is limited to just the defects that cause damage, meaning that nonstructural issues and economic losses arising from the defect are not recoverable.

All new residential developments are covered by NHBC ‘Buildmark’ or a similar scheme for 10 years, which is in effect a form of latent defects insurance that kicks in after 2 years from the date of completion. As such, purchasers or tenants of new residential buildings do not need to purchase a separate structural insurance policy where NHBC exists. You should carefully review the terms and conditions of the policy, and understand its limitations.

Negligence claim

In UK law, a recourse to professional negligence claims exists as an alternative to contractual claims. Legal restrictions on recovering "pure economic loss" in tort claims pose a challenge in construction contexts. "Pure economic loss" refers to financial losses rather than physical harm to individuals or property. While damages resulting from harm to other property or personal injury are compensable in tort, the costs of fixing the defect itself are considered purely economic and are typically not recoverable. For instance, if a property defect leads to personal injury, the losses from the injury may be claimed in tort, but the expenses of rectifying the defect are unlikely to be recoverable through this avenue.

What happens if a party breaches a collateral warranty?

As with any contract, if a party breaches the collateral warranty the other party (or parties) can make a claim for breach of contract. Claiming damages from the breaching party is one well-known remedy available to aggrieved parties. Depending on the nature of the warranty and what has been breached, different approaches to calculating damages may apply (ie based on wasted expenditure or loss of profit).  Where the breach is about quality or anticipated performance, a claimant if successful can elect to claim damages calculated by reference to its loss of profit, or losses incurred as a result of entering into the contract (whichever is higher). If the breach is about a negligent misstatement, for example, because of failure to take reasonable care when warranting any estimates given, then only wasted expenditure can be claimed, putting the aggrieved party in the same position as if the warranty was never made in the first place.

How can a party enforce a collateral warranty? 

Although seeking damages is common where a breach of collateral warranty occurs, an aggrieved party may wish to enforce the warranty and compel the breaching party to specifically perform the contract. For example, to ensure the party completes the works or delivers proper quality / workmanship if issues arise. If a default is identified, you should first notify the warranting party, outlining the specific breach and formally request remedial action within a specified timeframe. Before taking legal action, it is advisable to attempt to resolve the issue through negotiation or alternative dispute resolution methods.

Summary

A collateral warranty is a key legal contract that protects third party interests, providing a route for those not directly involved in the project to claim against the contractor or consultants in case of defects or failures. It provides a link between third parties affected by the defects (lenders, finders, purchasers and tenants), and the contractors or professional consultants responsible for the construction and workmanship of the building. Without such a contractual link, third parties may be left with limited or inadequate means to recover their losses.

Since the warranty involves the warrantor promising to a third party that it has complied with its obligations under the underlying building contract, the strength of the collateral is largely dependent on the terms of the building contract. It is therefore essential to conduct a thorough review of the underlying contract before accepting the collateral warranty.