Collateral warranties: an overview

Posted: 04/01/2013

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Everyone involved in the construction industry will be aware of the traditional contractual relationships that exist in the basic structure of most construction projects. That is, the employer contracts with the contractor, who in turn contracts with any sub-contractors and/or sub-consultants. This arrangement leaves the employer with no contractual relationship with any of the sub-contractors or sub-consultants.

This is not normally a problem provided the employer appoints a financially robust and competent contractor. In fact, in many instances the employer often prefers to have a contractual relationship with only one party because it creates a single point of responsibility. This means that should problems arise during construction, or, should a defect arise during the liability period, or later, the employer merely has to turn to the contractor to resolve it or to pay up.

However, there may be situations where this lack of contractual relationship with sub-contractors or sub-consultants could be problematic. These typically arise on contractor insolvency, whether during the construction or post completion. Here, if the employer’s only contract is with the contractor, the employer has no contract on which to seek damages and the doctrine of privity of contract prevents him using any agreement between the contractor and sub-contractor or sub-consultant as a means of redress.

Further, the employer is likely to face difficulties in bringing a tortious claim against sub-contractor/sub-consultant because of the restrictions places on the recovery of pure economic loss and because of the difficulty in establishing that a sub-contractor/sub-consultant owes a sufficient duty of care to a distant employer.

In order to address these problems, the employer can require the sub-contractor/sub-consultant to enter into a collateral warranty with them. This creates a direct contractual relationship between the two parties.

Key clauses

Collateral warranties typically follow a standard approach. Some are now standard form documents but many bespoke collateral warranties exist and they need to be read closely to fully understand their effect. The following are examples of the most common clauses. However, more complex projects will likely require tailored collateral warranties.

Consideration: collateral warranties are normally executed as a deed and so do not require consideration. However, sometimes the parties choose to include some nominal consideration just in case the deed is not executed properly. The collateral warranty will then take effect as a contract.

Principal covenant: this is where the sub-contractor/sub-consultant warrants that they have complied with the terms of their sub-contract/appointment. If they have a design responsibility they will also warrant that they have performed this duty with the skill, care and diligence to be expected from a person of the relevant profession.

Employers beware: the principal covenant is only as strong as the sub-contract/appointment. Employers should ensure the sub-contract/appointment includes all key terms and requires the sub-contractor/sub-consultant to exercise a good degree of care. If not, the value of a collateral warranty will inevitably be limited.

Non use of deleterious materials: the sub-contractor/sub-consultant warrants to the employer that he will not use or specify materials that will be deleterious to any part of the works.

Step in rights: these can be very important. They allow the employer to ‘step into the shoes’ of the contractor if the contractor becomes unable to complete the construction – typically through insolvency. In the current economic climate where contractor insolvency is all too common, this clause can be of great importance. However, the sub-contract/appointment should be drafted to make the exercise of these rights optional: for example, the employer may not wish to insist on stepping in as this may not be financially prudent for the employer depending upon the overall financial position of the sub-contract/appointment.

Copyright: many collateral warranties will contain a copyright clause allowing the employer to use any design documents the sub-contractor/sub-consultant prepares. The licence should be royalty free, irrevocable, non-exclusive and include the right to assign.

PI insurance: if the sub-contractor/sub-consultant has design responsibility, the collateral warranty will require that PII is kept in place for the full length of the warranty, typically 12 years if in deed form or six years if in contract form.

Liability period: this will again be 12 years if the collateral warranty is executed as a deed and six if a contract. Employers should seek a liability period equal to the liability period under the building contract.

Assignment: there is usually a restriction on the employer’s ability to assign; often the collateral warranty will provide that two assignments are allowed. Subject to the nature of the works, and whether or not they are likely to be sold often, the warranty may need to expressly provide for assignment more than twice throughout the 12 year period.

Limitations

The sub-contractor/sub-consultant will want to try and limit his liability under the collateral warranty. The most common method of doing this is the use of “no greater duty” and “equivalent rights defence” clauses. These state, respectively, that the sub-contractor/sub-consultant owes no greater duty to the employer than he does to the contractor under the professional sub-contract/appointment and that the sub-contractor/sub-consultant may use any defence available under the sub-contract/appointment when defending any claim under the collateral warranty. In addition, the sub-contractor/sub-consultant will try to limit what can be recovered to make repairs or take remedial action. For example, if consequential trading losses can be claimed, this may be prohibitively expensive.

The sub-contractor/sub-consultant may also try to use a net contribution clause, though the use of these is fairly controversial and usually a matter for negotiation. As often, commercial bargaining power will probably determine who triumphs.

The effect of a net contribution clause is to adjust the default position of joint and several liability. That is, normally, the employer would be able to recover all losses from just one sub-contractor/sub-consultant. The responsibility would then be on that particular sub-contractor/sub-consultant to recover the money he has paid out over and above his ‘fair share’ (i.e.: the proportion of damages attributable to his breach) from the other sub-contractors/sub-consultants by reference to the Civil Liability (Contribution) Act 1978. However, a net contribution clause limits the employers recovery from each sub-contractor/sub-consultant to that which is “just and equitable.” In such circumstance the employer therefore needs to sue all sub-contractors/sub-consultants individually and demonstrate the amount of their contribution. All of this can be significantly harder for an employer than simply demonstrating that damages are due from any one of the sub-contractors/sub-consultants.

Sub-contractors/sub-consultants often push for such net contribution clauses because they push the risk of another sub-contractor’s/sub-consultant’s insolvency and the risk of litigation onto the employer. Employers will wish to resist them for the same reasons.

In the current economic climate when everyone is aware of the increased likelihood of contractor insolvency, the allocation of this risk is often hotly negotiated.

Court’s view

It is perhaps surprising given their prevalence but cases concerning collateral warranties before the English courts are not large in numbers. However, where they have been discussed, it appears the court supports the commercial principle behind collateral warranties; How Engineering Services Ltd v Southern Insulation (Medway) Ltd [2010] and Linklaters Business Services v McAlpine Ltd and others [2010].

Cases concerning net contribution clauses are rarer still. However, the Scottish courts have stated that, even though they seek to limit liability, the clauses do not fall foul of the Unfair Contract Terms Act 1977 (Langstane Housing Association Ltd v Riverside Construction Aberdeen Ltd & Ors [2009] ScotCS CSOH 52). Whilst this view is not widely supported by legal practitioners, it is by institutions such as RIBA and ACE.

Alternatives

Alternative options to the use of collateral warranties are assignment and third party rights. Neither have proved particularly popular. The trouble with an assignment is that it can only be used once and the Employer may also want to keep part of the benefit. Third party rights are potentially more useful. In fact, they may be more efficient, requiring modified drafting to only one document. However, although use of third party rights has been available since the Contracts (rights of Third Parties) Act 1999 came in to force in November 1999 these have not been widely used and few within the construction industry after familiar with them.

Other requests

Other involved parties may also request collateral warranties. These include any future tenant or purchaser of the property, and freehold owner or any funder of the project.

Conclusion

Arranging and securing fully executed collateral warranties can be hugely time consuming. Many involved in the construction industry are not fans of collateral warranties for this reason. However, those who are putting up the money for projects, whether they be employers or funders, fully recognise the value of securing well drafted collateral warranties and collateral warranties are likely to be around for some time to come.

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