Collateral warranty

Guide to Collateral Warranty in Construction

Construction has returned, and every construction project has a suite of construction documents. One of these documents is a collateral warranty, which gives an overview of the purpose of the collateral warranty and a few points for reviewing the draft.

What is a Collateral Warranty in Construction?

A Collateral Warranty is a contract in which a consultant, building contractor, or subcontractor warrants to a third party that they have fulfilled their professional appointment, building contract, or subcontract.

Collateral warranties are used as a supporting document to a primary contract when an agreement with a third party outside of the primary contract is needed. An architect, contractor, or subcontractor may be needed to provide a warranty to a funder, tenant, or purchaser that it has fulfilled its duties under a building contract.

Collateral warranties often contain obligations affecting the consultant or contractor, such as using proper materials and performing work in a professional, workmanlike manner. It can also grant third-party contractual rights, enabling it to claim back losses that would otherwise be unrecoverable.

Collateral Warranty Example

When an employer contracts with a Main Contractor and the Main Contractor then contracts with a number of subcontractors to complete the work, the Employer has a direct contractual relationship with the Main Contractor but no contractual relationship with any of the subcontractors (this is known as ‘privity of contract’).

In some cases, the Employer may wish to enter into a direct contractual relationship with the subcontractor in order to directly enforce the subcontractor’s obligations or to create further obligations and rights between them. This could be considered as a security precaution if the Main Contractor becomes insolvent or if its employment is terminated for any reason. In such cases, some warranties grant the Employer the right to “step in” to the place originally occupied by the Main Contractor.

Before design and build forms of contract became prevalent, collateral warranties were usually used to create a direct contractual relationship between the Employer and a subcontractor for any design work carried out by the subcontractor.

What Are Third-Party Rights?

A third party right is the right of someone who wasn’t a party to a contract (a third party) to enforce the benefit of a contract term.

For example, a funder may have the right to enforce the following terms:

  • A professional appointment entered into between the employer and its architect, engineer or quantity surveyor.
  • A building contract entered into between the employer and its contractor.

A construction contract often states that a third party cannot rely on the Contracts unless the contract clearly allows third-party rights. A construction contract that includes third-party rights typically includes them in a schedule to the building contract or professional appointment.

From Who Are We Required to Get Collateral Warranties?

It may be desirable to require the Main Contractor to provide warranties in favor of the Funder, as well as future purchasers and tenants. This may be a term of the funding agreement in any case for funders; for purchasers and tenants, it may increase the value of the asset they are purchasing because it gives them direct recourse to the Main Contractor for any issues they may have with the building during their occupancy or ownership.

If the design is being handled by a specialist subcontractor, it is a good idea to have a collateral warranty agreement in place to establish a direct contractual relationship.

What Does a Collateral Warranty Include?

It is essential that the subcontractor collateral warranty is consistent with the underlying contract to which it relates, and certain clauses are expected in any collateral warranty, such as:

  • A guarantee that the warrantor has fulfilled and will continue to fulfill their obligations under the underlying contract (whether the building contract, appointment, or subcontract) and will carry out any design with reasonable skill and care.
  • The grant of a copyright license to use/reproduce any designs, drawings, calculations, or other works produced by the warrantor; and
  • An obligation to maintain professional indemnity insurance at a certain level for a specified number of years after the project is completed.

Collateral warranties may also include various liability caps that seek to limit the warrantor’s liability to the collateral warranty beneficiary. Such clauses can include a financial cap on the warrantor’s liability, a net contribution clause, and a no greater liability clause, which limits the warrantor’s liability to the underlying contract’s liability.

It is worth noting that the warrantor’s covenant (that they will fulfill their obligations under the underlying contract) is only as strong as the underlying contract. Any review of a proposed form of collateral warranty should not be done in isolation, and a copy of the underlying contract should be provided to ensure that all key terms are included.

Main Points of Negotiation in the Collateral Warranty

  • Insurance – The Collateral Warranty will specify how long the insurance policy must be maintained and at what level it should be. In practice, this can be difficult to manage, especially after the project has been completed. It can be difficult to ensure that the contractor or consultant maintains the required level of insurance after the project has been completed.
  • Duration of Collateral Warranty – Collateral Warranties typically range from 6 to 12 years. The beneficiary of the Collateral Warranty will want it to last as long as possible, whereas the contractor or consultant will want it to last as little as possible.
  • Step In Rights – This enables the beneficiary of a Collateral Warranty to step into the employer’s shoes in the event that the employer becomes insolvent, allowing the beneficiary to complete the project.
  • Assignability – This is a critical point for a contractor or consultant. It will specify how many times a Collateral Warranty can be assigned to a third party. In practice, it usually provides for two assignments without the contractor’s or consultant’s consent, and any further assignments must be with the contractor’s or consultant’s consent.

Collateral Warranty Insurance

Finally, organizations that provide collateral warranties must consider a number of insurance considerations. A collateral warranty may increase a contractor’s overall liability by increasing the number of organizations that can make a claim against it and extending the time period after construction in which a claim can be brought.

On the one hand, this emphasizes the importance of carefully considering collateral warranty wording – for example, including ‘no greater liability’ clauses and clauses limiting the warranty period.

It is also important to review professional indemnity (PI) insurance arrangements. Design failures are picked up by PI policies, but construction issues, such as workmanship, are not. As a result, before finalizing a collateral warranty, it is critical to seek the advice of an expert broker to ensure that the existing policy provides sufficient protection.

Conclusion:

In terms of best practice, commercially, it would be best to specify in the tender documentation, pre-contract, that collateral warranties will be required as a condition of the contract or subcontract and provide a draft of the warranty form so that the requirements are known at the outset.

Seeking to impose the requirement post-contract may prove to be both costly and difficult to achieve.