by Nicholas Lightbody and Angus Hutcheson
Most readers will have more than a passing knowledge of the convoluted and tortuous path that the developer has been pushed along in obtaining collateral warranties from each member of his professional team since D & F Estates Ltd v Church Commissioners for England [8] 2 EGLR 263. This has been caused by pressure from financial institutions, purchasers and tenants to secure a direct contractual link with contractors and members of the professional team in order to avoid having to rely on rights in tort if latent defects should become evident during the ensuing years.
The recent decisions of the House of Lords in Murphy v Brentwood District Council [0] 3 WLR 414 and Department of the Environment v Thomas Bates & Son [1990] 46 EG 115, have served to emphasise the prudence shown by the financial institutions and later occupiers of the development who insisted on collateral warranties before agreeing to fund the development or to enter into a purchase agreement for the freehold or the leasehold interest.
Developer’s considerations
In considering the form of collateral warranties that the professional team should be obliged to provide under the terms of their respective contracts of engagement or building contract, the developer will need to be aware of the following considerations:
(1) The professional team will not wish to extend their own liability any further than is absolutely necessary.
(2) It is essential that any relevant professional indemnity insurers have approved the terms of the collateral warranty to be given by their insured in view of the numerous exclusions that presently apply to such policies. On the other hand, although currently many funders will be particularly concerned as to the extent of the professional’s PI cover, that cover is merely an annual contract under which the insurer has no obligation to maintain insurance from one year to the next. As a result there is certainly some basis for the view that a third party should not place much reliance upon the PI insurance as an avenue for future recourse in the event of claims against the professionals arising.
(3) Even if the professional team’s agreement to provide certain forms of collateral warranty can be obtained, there is every possibility that potential funders, purchasers or tenants will require rather more rigorous forms of warranty by the time that the project has advanced to the stage where funding can be obtained or purchasers sought.
(4) The net cost of obtaining collateral warranties may be considerable. It is necessary to take into account the combined legal costs of the parties; the cost of the parties’ own time spent in negotiating; the potential cost to the developer of the completion of the funding being delayed; and the damage to the developer’s working relationship with his professional team caused by acrimonious negotiations.
British Property Federation standard form
Readers will be aware of the recent promulgation by the British Property Federation of a form of collateral warranty intended to be given to the funder of a development. John Martin expressed in his recent article, The BPF Collateral Warranty [0] 37 EG 62, his view that the BPF form may for several reasons be unacceptable to an institutional funder. In particular, the present limitation on the assignability of the collateral warranty may be regarded by a funder as constituting a defect. The funder would clearly wish to be able to pass the benefit of the collateral warranty on to a purchaser if the funder had to enforce the security. The funder’s inability to do so would not serve to enhance his enthusiasm for the proposed development. Despite the deep concern felt by architects and others on this issue, we believe it is realistic to anticipate that the requirements of any potential funder, purchaser or tenant for collateral warranties will become more rigorous than was the case before the recent House of Lords decisions. If the BPF’s form is not generally accepted the difficulties facing the developer in the future will be compounded.
It is clear that the recent developments in the general law have increased the importance of collateral warranties in the absence of other recourse and have made the developer’s position ever more difficult as he attempts to balance the expected demands of funders against the understandable reservations of the professionals, their PI insurers and the contractor.
“BUILD” report recommendations
The BUILD report, published by the National Economic Development Office in October 1988, concludes that current arrangements for handling the aftermath of the discovery of latent defects do not deal satisfactorily with the interests of the various parties involved. The report recommends the creation of a different route to obtaining redress, namely a “first party material damage insurance”, which would ensure the repair of defects and damage covered by such a policy without proof of fault. It was envisaged that this BUILD (Building Users Insurance against Latent Defects) policy would be negotiated by the developer or building owner at the preliminary design stage. The report recommends that the essential features of such a policy are, inter alia, as follows:
(i) non-cancellable material damage insurance against specific latent defects and damage;
(ii) protection for a period of 10 years on payment of a single premium with cover starting from the date of practical completion;
(iii) cover initially limited to structure (including foundations), the weather-shield envelope and, optionally, loss of rent;
(iv) the policy to be drawn to benefit or to be transferable to successive owners and to whole building tenants;
(v) waiver of insurer’s subrogation rights against the professional team; and
(vi) risk assessment and verification during the stages of both design and construction to be undertaken by independent consultants appointed by the insurer.
Cover in a similar form to that recommended by the BUILD report is now available from a number of British and continental insurers: see, for example, the Sun Alliance “Building Defects Insurance Policy”, the Commercial Union “Latent Defects Policy” and the SCOR (UK) “Inherent Defects Insurance Policy”. The decennial, or 10 year, cover provided by these policies is generally extendable on payment of additional premiums to include weather-proofing, mechanical and electrical services installations, seepage and loss of rent. The insurers at the outset specifically exclude any waiver of subrogation rights they may have against the professional team. However, this, with other aspects of this new type of policy, is probably negotiable.
The cost of obtaining such insurance, including the professional fees payable to the insurer’s technical inspector, may be assumed to be in the region of 1.5% of the current construction contract value, which would thus add roughly between 0.5% and 0.65% to the cost of an office development in London. This cost should be offset by savings in expenditure which would otherwise be incurred referred to above and, in the event of defects becoming apparent, the economic loss arising from the development remaining vacant or part vacant and the unproductive time and money incurred in disputes with the professional team and consequent litigation.
We have assumed that the decennial insurer will not impose any requirement for collateral warranties of its own upon the professional team. We are unaware of such requirements to date which, if they arose, would, in our view, negate much of the value of the decennial insurance.
There is scope for an integration of the inherent defects insurance with the professional team’s PI cover since there is inevitably some overlap, and we envisage that professionals may see some merit in forming single-project companies for each commission just as developers presently do. The professionals and the developer would then together purchase combined inherent defects and professional liability insurance cover under which the inherent defects part of the policy would be assignable to future owners or occupiers of the building.
European proposals
Mandatory single-project insurance tied into construction liability limited to 10 years for all member states was raised within the Mathurin Report to the European Commission which was finalised as a working document in January 1990 by French civil servant Claude Mathurin. Italian lawyer Renato Caronna has now been brought in by the commission to progress legislation within these areas. A working document produced by him refers to implementing proposals covering only the residential sector, with commercial developments and civil engineering works to be dealt with later. From the UK, great reservations have been expressed by the Construction Industry Council regarding such a split system. Further European developments can be expected shortly.
In practice
In practice, having negotiated the proposed decennial insurance policy with the insurer, the insurer will enter into an agreement with the developer to provide the insurance at practical completion subject to any qualifications that may arise upon the insurer’s receipt of the technical inspector’s report. Assuming that the design and construction processes have been properly conceived and supervised, the developer should expect that an unqualified report would be issued by the inspector resulting in the issue of an unqualified policy by the insurer.
Conclusion
In an uncertain market, we envisage that the additional cost of obtaining decennial insurance may be outweighed by the increased marketability and, indeed, the potential value, of the development both in terms of ease of obtaining funding and in relation to disposal. The developer will have saved the costs and the impaired working relationship with the professional team which would arise at the outset through interminable negotiations over required collateral warranties. Further, when negotiating with the proposed lead tenant, protection offered by the decennial policy should provide the developer with a substantial selling-point.
Few people today would consider buying a new domestic property without an NHBC guarantee. Decennial insurance can provide an effectual “NHBC guarantee” for a commercial development and we believe that this will become an increasingly popular strategy.
