Back to Basics: Collateral Warranties

In construction projects, a collateral warranty is an agreement where a party involved in the works assures a third-party beneficiary, who is not a party to the underlying contract but has an interest in the works, that it has met (or will meet) its obligations under the underlying contract. The underlying contract could be a building contract, sub-contract, or professional appointment.

The basics of contract law are such that only parties to a contract can enforce its terms (doctrine of privity of contract). This means that if a party is adversely affected by a breach of a contract to which they are not a party, they generally have no right to enforce the terms of that contract. Without a contractual relationship, the party adversely affected may have to rely on a claim in negligence, which would limit the recoverable damages.

Under a collateral warranty, the warrantor warrants to the beneficiary that it has complied (or will comply) with the underlying contract. This gives the beneficiary the right to make a contractual claim against the warrantor in the event of a breach of the terms of the collateral warranty and, by extension, the terms of the underlying contract.

In a typical construction project, an employer contracts with a contractor to carry out building works, establishing a clear contractual relationship through a building contract. However, projects usually involve many parties beyond just the employer and contractor, such as funders, purchasers, contractors, sub-contractors, sub-consultants and even sub-sub-consultants/contractors. Many of these parties would not have direct contractual links with each other.

Collateral warranties are used to bridge the contractual gap by creating direct contractual relationships for the benefit of those parties that might otherwise have no legal recourse. These warranties can also contain ‘step-in’ rights which allow the beneficiary to 'step into’ the underlying contract. For example, an employer could step into the shoes of a contractor, effectively substituting them as a party in the contract between a contractor and sub-contractor. This is particularly useful if the main contractor becomes insolvent, as it enables the employer to step into the contractor's role and ensure that a sub-contractor continues to fulfil its obligations, and ultimately take the project through to completion.

What are the contents of a Collateral Warranty?

Given the above, a collateral warranty is a crucial document in the construction industry, serving as a safeguard for third parties. At its core, a collateral warranty outlines the specific duties and responsibilities of the contractor or consultant, ensuring that their work complies with the terms of the underlying contract. 

The warrantor will be hesitant to accept additional obligations that could increase its liability to the beneficiary over and above the underlying contract. In contrast, the beneficiary will want to ensure that the warrantor cannot evade liability under the collateral warranty. Bringing both viewpoints together, the terms of a collateral warranty usually seek to mirror the terms of the underlying contract as closely as possible. Therefore, it is common to see “no greater liability” clauses, as well as equal rights of defence clauses, confirming that the warrantor’s obligations and liabilities under the collateral warranty are the same as in the underlying contract.

A collateral warranty specifies the duration of its validity, any limitations or exclusions of liability, and the procedures for making claims. By clearly defining these elements, a collateral warranty offers a robust framework that protects the interests of all parties involved, ensuring confidence and security in construction projects.

A collateral warranty will typically include several key covenants that outline the obligations and assurances of the warrantor to the beneficiary, which often include:

1. Performance Obligations: the warrantor commits to carrying out and completing the development in accordance with the terms of the original contract, which includes warrantor’s duty of care in performing their services to a particular level of skill, care and diligence. As explained above, this is essential to ensure that the work complies with the terms of the underlying contract.
2. Insurance Requirements: the warrantor agrees to maintain professional indemnity insurance for a specified period, often up to twelve years after the completion of the project. This provides financial protection in case of defects or issues arising from the work during the project or following completion.
3. Non-Variation Clause: the warrantor agrees not to vary, amend, waive, or supplement the terms and conditions of the original contract without the prior written consent of the beneficiary. This ensures that the beneficiary's rights are not compromised by changes to the original agreement.
4. Assignment Rights: the collateral warranty may include provisions allowing the beneficiary to assign the warranty to another party, typically without the warrantor's consent. This is important for the transfer of rights in case of property sales or changes in project ownership following completion.

These covenants help to establish a clear and enforceable framework that protects the interests of all parties involved in a construction project.

On 9 July 2024, in the case of Abbey Healthcare (Mill Hill) Ltd v Simply Construct (UK) LLP 1¹,  the Supreme Court unanimously confirmed that collateral warranties are not considered construction contracts for the purposes of section 104(1) Housing Grants, Construction and Regeneration Act 1996 (the “Construction Act”). You can read the judgment here.

Importantly, the Supreme Court held that a construction contract under the Construction Act is defined as an agreement for the carrying out of construction operations and was not intended to cover collateral warranties when it was drafted.

The dispute between the parties related to alleged fire safety defects at a care home in North London. Abbey Healthcare (Mill Hill) Ltd, the tenant, was provided with a collateral warranty by the contractor, Simply Construct (UK) LLP (Simply Construct). The collateral warranty contained a provision that Simply Construct had performed and would continue to perform diligently its obligations under the underlying contract.

Initially brought in the Technology and Construction Court, it was held, on first instance, that the collateral warranty was not a construction contract. The judge said that by “applying commercial common sense” it would be difficult to see how a collateral warranty could be construed as a construction contract when it was executed four years after practical completion of the project. In the Court of Appeal, the court suggested that a collateral warranty could be a construction contract but could not agree on whether this collateral warranty was a construction contract. By a split majority, the Court of Appeal disagreed with the first instance judge.

The judgment in the Supreme Court was handed down by Lord Hamblen. He confirmed that the collateral warranty between the parties was not a construction contract. A construction contract under the Construction Act is defined as an agreement for the carrying out of construction operations. Lord Hamblen said that there would need to be a “separate or distinct obligation to carry out construction operations”. He said that it was difficult to see how most collateral warranties could be defined in this way.

What does this judgment mean for the Construction Industry?

The outcome of this judgment is that most collateral warranties will not be considered construction contracts under the Construction Act, unless they contain distinct and separate undertakings in relation to construction operations that are not already part of the underlying agreement to which the collateral warranty relates.

The primary impact of this judgment is that parties to collateral warranties can no longer rely on the Construction Act for a statutory right to adjudicate as is the case for construction contracts. If parties want the right to agree to adjudication, they must explicitly include clear wording to that effect in the collateral warranty.

TPR clauses – a ‘modern’ alternative?

Notwithstanding our comments above in relation to general privity of contract and use of collateral warranties, the construction industry was keen to develop a new approach. Collateral warranties can be time-consuming and expensive to procure. Whereas TPRs are provisions within the underlying contract that allow third parties to enforce certain terms of that contract without the need for a separate agreement. This approach is based on the Contracts (Rights of Third Parties) Act 1999, which enables third parties to benefit from and enforce contractual terms directly.

It is important to note that both collateral warranties and TPRs can provide effective security to a third-party beneficiary in construction projects.

The main difference lies in the formality and specificity of the agreements. Collateral warranties are standalone documents that explicitly outline the rights and obligations of the parties involved, while TPRs are embedded within the underlying contract, offering a more streamlined approach.

For now, the construction industry often prefers collateral warranties. The industry is much more familiar with collateral warranties, as they have been used for a long time and the industry is comfortable with their structure and enforceability, perhaps due to all parties receiving a signed document confirming their contractual relationships. It remains to be seen whether TPRs will become the norm in construction projects as the perceived risk and administrative burden reduce, and familiarity with TPRs increases.