Collateral warranties are regularly used legal documents within the commercial real estate sector when selling, leasing or funding a newly built or significantly refurbished building.
Well-advised funders, purchasers and tenants (especially those with insuring and repairing obligations) usually require contractual protection from the parties that have designed and/or constructed such works. Using the Contracts (Rights of Third Parties) Act 1999 as an alternative to collateral warranties is becoming more common. This article sets out a brief explanation as to what collateral warranties and third-party rights are and why they are needed.
What are they?
It was in the 1990s that collateral warranties came to prominence following the House of Lords decision in Murphy v Brentwood District Council [1991] UKHL 2.
It would be remiss not to then borrow a phrase from a well-known TV advert of the era to help explain what a collateral warranty is – it does exactly what it says on the tin: a collateral warranty is an agreement containing various warranties which are collateral to another agreement.
Although it is “collateral”, it is a separate agreement between the obligor under the original contract (the warrantor) and a third party that is not a party to that original contract (commonly referred to as the beneficiary). Generally speaking, the purpose of a collateral warranty is to give the beneficiary certain contractual rights regarding compliance by the warrantor with the terms of the underlying contract and additional rights such as a copyright licence or those conferred by substitution provisions (also known as “step-in rights”).
Many of these contractual rights can also be granted making use of the 1999 Act as an alternative to a collateral warranty. For rights to be conferred, the Act holds that the contract has to expressly provide that rights are to be conferred on that party or its terms must purport to confer a benefit on such party. It is commonplace that contracts include a boiler-plate provision excluding application of the Act and so careful consideration should be given to any contract under which it is intended that a third party may rely on its terms pursuant to the Act.
When conferring the various rights, it is common for the relevant rights either to be set out in a schedule to the relevant contract, with relevant beneficiaries being expressly identified in the contract if known at the time, or for the rights to be referred to by reference to clauses in the contract.
To cater for beneficiaries whose identity may not be known at the time the contract is entered into, it is common for classes of permitted beneficiaries to be identified in the contract, with a notice served on the warranting party identifying the specific beneficiary at a later date. While the objectives of collateral warranties and third-party rights are the same, there are subtle legal differences and the use of third-party rights has not been fully tested in the courts. There are also questions of the suitability of third-party rights in dealing with step-in rights so 1999 Act rights are often not accepted by funders in place of a collateral warranty.
The rights granted by collateral warranties/third-party rights are additional to those contained in the underlying contract, rather than a transfer of such rights (which would be an “assignment”).
Why are they needed?
A person not a party to a contract cannot benefit from its terms. This concept is known as privity of contract. While a person deprived of contractual rights who has suffered a loss as a result of another party’s wrongdoing could bring a claim in tort – provided it is able to establish a duty of care, a breach of that duty and causation of its loss – it is unlikely the losses arising out of the breach of the tortious duty of care (if established) would be recoverable. A third party can also make a claim under statute in particular circumstances.
“Pure economic loss” is not recoverable via a tortious claim (see Spartan Steel and Alloys Ltd v Martin and Co Contractors Ltd [1973] 1 QB 27 and, in Murphy v Brentwood, it was held that the cost of repairing building defects constitutes pure economic loss. Losses due to the inability to occupy the building while defects are repaired or depreciation in market value are also examples of pure economic loss.
Such limitations on recoverability do not apply to contractual claims and so a collateral warranty or the granting of third-party rights resolves this fundamental issue and opens the door for recovery of such losses by a person who is not a party to the relevant contract. It also allows that party to benefit from the enhanced obligations that are contained in a contract.
Collateral warranties and third-party rights do not just provide a contractual right to claim in respect of defective works but usually also provide:
- A copyright licence in favour of the beneficiary to use and reproduce project documents for purposes relating to the project;
- An obligation on the warrantor to take out and maintain professional indemnity insurance at a required level while it has potential liability to the beneficiary; and
- A right for the beneficiary to “step-in” to the position of the warrantor’s client.
The ability for a third party to step in to a contract is important for funders and developers alike. A developer will likely only be party to the building contract and the agreement with its retained professional team (such as a project manager and quantity surveyor), whereas its design and build contractor (for instance) will likely have agreements in place with various design consultants and subcontractors who carry out the works.
A well-advised developer will also obtain warranties from such parties which include step-in rights as soon as possible so that the developer has the ability to step-in to such agreements and employ the counterparties directly in the event that the main contractor becomes insolvent – something which is unfortunately all too common in the UK construction market.
Similarly, funders require step-in rights should the developer itself suffer financial difficulties, although the use of step-in rights by funders is not actually that common.
Privity of contract
Forms
There are various industry forms of collateral warranty which are published for use alongside industry standard form building contracts and appointments, such as JCT, CIC, ACE and RIBA.
From a developer/beneficiary perspective, industry standard form warranties tend to include limitations on liability that should not be acceptable to well-advised parties and are unlikely to be acceptable to funders.
Instead, it is common that bespoke collateral warranties are agreed between parties to ensure that the relevant parties’ interests are reasonably and adequately protected.
Key takeaways
- Warranties/third-party rights provide a contractual course of action which is needed to recover cost of rectifying defects, loss of rent or loss in value
- They are only as good as the underlying contract
- Industry standard form warranties may not be acceptable to funders and investors
Next time We cover lease renewal and redevelopment under the Landlord & Tenant Act 1954
Adam Jason is a legal director in the construction team at Brabners
