For construction lawyers, the merits of third party rights versus collateral warranties is a tiresome debate. The legislation was passed more than 16 years ago. Even so, the arguments rumble on.
Collateral warranties exist because the courts ruled that third parties could no longer recover economic losses through the tort of negligence. That left developers of real estate projects with a sudden difficulty: funders, tenants and buyers rely on the construction team’s performance.
The disappearance of tortious liability meant that rights had to be secured in another way. The most practical solution was to create contractual duties of care. However, that brought privity of contract to the fore. This doctrine holds only the parties to a contract can enjoy and enforce rights under it.
Collateral damage
Developers could, however, circumvent privity by obliging construction parties to enter into separate agreements with the beneficiaries. Soon these collateral warranties flooded the market. Yet drawbacks were quickly apparent.
The developer, warrantors and beneficiaries all wanted their lawyers involved. That proved expensive. And, of course, the instruments needed to be executed. While this inconvenienced them, signing hands also granted warrantors leverage. If they had a grievance with their employer, they could withhold a warranty knowing that this would likely cause it to breach an obligation to a third party. Employers could force compliance through claims for specific performance (adding yet more legal expense) but how many were minded to play call my bluff?
Countermeasures existed to curb insubordination. But construction parties are notoriously suspicious of any legal chicanery. Agreeing these could be almost as much trouble as they were worth.
Fortunately, some had remembered that warranties were a workaround, not an antidote. They pressed for the law to be modernised to allow contracts to vest rights in third parties. The Law Commission produced the first draft of what became the Contracts (Rights of Third Parties) Act 1999 (“the 1999 Act”).
This legislation created a new exception to privity in England, Wales and Northern Ireland. The rest should have been history. Warranties would, surely, swiftly go the same way as mercury thermometers, abandoned once a less-perilous alternative emerged.
Except this didn’t happen. The market stuck with what it knew – warranties.
The rise and stall of third party rights
Then in 2005 came a breakthrough. The JCT and the NEC decided to implement third party rights across their construction contract suites. The sector could no longer turn a blind eye to their existence. At the time, I predicted a tipping point was in sight. I was wrong. While the move triggered an initial wave of awareness and adoption, momentum subsided. When I carried out a large-scale survey of industry opinion to mark the 10th anniversary of the 1999 Act, I was less bullish.
Sure enough, respondents were split. Sceptics had two primary doubts over the effectiveness of these third party rights. The first was that the rights were untested in the courts (a rather peculiar reason, given their legislative source). The second was that “step-in”, which allows a beneficiary to take the employer’s place under its appointment with the warrantor, might be inoperable since obligations could not be imposed on beneficiaries.
These are well-worn myths and, besides, similar doubts had been raised upon the introduction of collateral warranties. Third party rights had featured in court cases. As for step-in rights, many lawyers had taken to drafting another workaround: step-in provisions so that a valid beneficiary’s notice triggering them must include a binding undertaking to discharge the developer’s obligations.
But a notable proportion of property and development finance agreements continue to specify collateral warranties. Why is this happening?
One view is that many of these commercial agreements are based on aged precedents, which are patched up regularly but rarely undergo a root-and-branch review that would identify efficiencies. More crucially, there’s that “if it ain’t broke…” attitude. Beneficiaries, possibly spooked by the misconceptions, can be reluctant to switch. In turn, developers wonder if it’s worth rocking the boat.
Collateral warranties, for their flaws, work fine most of the time. For more-modest projects, the savings in legal fees that third party rights bring are more often counted in the tens of thousands not the hundreds. In the context of these property transactions, the issue is one of the lesser concerns.
Still, third party rights are better in every way. Plus, all that time and money adds up. So how do we accelerate the transition?
Embrace change
Developers should do more to push third party rights. They drive the market and can help bend beneficiaries to their will. Leading property companies have the most to gain and are long-term planners. Others should emulate that outlook.
Contract administrators and lawyers have a moral imperative to promote best practice. They ought to provide conscientious opinions free of jargon. Critically, they should not be caught rubbernecking.
Last but not least, industry bodies should reclaim a direct role. I mentioned the decline of mercury thermometers. In reality, this was largely precipitated by government restrictions. Consumers, it seems, were content to keep buying potential death traps. It shows we cannot rely on the market alone.
The JCT contracts will be updated this year. Until now, the publisher has hedged its bets by retaining the option for collateral warranties. It is not too late for its 2016 editions to remove this. It would be a bold shift but it would set the tone.
Third party rights are the new dawn. We cannot keep looking backwards.
Francis Ho is head of construction at Olswang LLP
