A Guide to Collateral Warranties on Construction Projects

In this article, we consider collateral warranties, which are often used on construction projects, and we explain what they are, why they may be required, some alternatives to collateral warranties (such as third-party rights) and which parties are likely to give and receive collateral warranties.

What are Collateral Warranties?

In UK law, there is a doctrine of privity of contract which prevents a person who is not a party to a contract from enforcing a term of that contract. The general rule is very simple: only the parties to a contract may sue on it or be sued for breach of its terms. In the context of construction projects, this means that only the employer is able to enforce the terms of the building contract or any professional appointments, for example, that of an architect or structural engineer.

However, other parties often have an interest in the works either during construction or once the works are completed, such as funders, lenders, purchasers, and tenants. It is also often the case that defects may not arise or be discovered until some time after the works have been completed, with the party that is actually affected by the defect being the person in occupation, i.e. the purchaser or tenant.  

If those third parties suffer a loss, such as lost income, or they have to incur the costs of rectifying the defect, then they will be the persons who will need the ability to pursue a claim against the contractor or the professional consultant responsible for the defect. However, since they are not a party to the building contract or professional appointment, they will be unable to pursue a contractual claim under the building contract or professional appointment.  

An alternative to a contractual claim is to bring a claim in tort as a result of negligence. However, in UK law, there are legal limitations on the ability to recover what lawyers refer to as “pure economic loss” in claims in tort, which causes a particular issue in the context of construction claims.  

Economic loss is effectively a financial loss as opposed to damage to a person or property. 

For example, if the defect causes damage to other property or personal injury, then that damage would be recoverable in tort, but the problem is that the costs to rectify the defect itself are purely economic and are unlikely to be recoverable in tort. So if a property has been constructed improperly and it injures an occupier, a claim for the losses arising from the personal injury would be recoverable in tort (subject to satisfying the other requirements for a claim in tort), but the costs to rectify the defect would most likely not.

Since there is unlikely to be an ability to bring a claim for the costs to rectify the defect in either contract or tort, the interested third parties need another route, and this is where collateral warranties come in. A collateral warranty creates a contractual link between the third party and the contractor or professional consultant.

A collateral warranty is a contract that sits alongside the underlying contract, such as a building contract or consultant appointment, and grants rights to a third party which can be sued upon. 

A collateral warranty is much shorter than the underlying contract because, to a large extent, it relies upon the terms of the underlying contract. In the collateral warranty, the warrantor will warrant to the third party that it has performed its duties and obligations in accordance with the underlying contract. Therefore, if there is a breach of the underlying contract, that will usually trigger a collateral warranty breach. This is a key point to note in relation to a claim under a collateral warranty. It is effectively a claim for a breach of the promise to comply with the underlying contract.  

The limitations regarding “pure economic loss” mentioned previously do not apply to contractual claims, so the costs of rectifying the defect would be recoverable as well as any other pure economic losses such as lost income or profit. 

In order to obtain collateral warranties, the underlying building contract, appointment or sub-contract will need to expressly provide that the contractor, consultant or sub-contractor is required to provide collateral warranties to third parties. Collateral warranties may be provided to third parties during the course of the works or after completion.

When a collateral warranty is provided, it is essential to ensure that it has been signed correctly by the right people. Any failure to execute a warranty correctly can affect its validity.

There are some standard forms of collateral warranty, such as those published by JCT and the CIC, but these forms contain several limits on the liability of the person providing the warranty, and they may not be acceptable to the third party. In practice, most employers will usually use their own bespoke forms of collateral warranty.

Are there any alternatives to collateral warranties?

There are some alternative ways to grant rights to the interested third rights in construction projects.  

The Contracts (Rights of Third Parties) Act 1999 alters the doctrine of privity of contract and, in certain circumstances, allows a third party to enforce the terms of a contract made between other parties for its benefit.  

The granting of rights in this way is a viable alternative, but the underlying contract often excludes third party rights, and many parties still prefer to receive collateral warranties. If third party rights under The Contracts (Rights of Third Parties) Act 1999 are to be adopted, then this has to be dealt with in the underlying contracts at the outset, which is still a fairly rare occurrence.

Another way to grant rights to third parties is by assigning the rights under the original contract, but this is not always appropriate. For example, an employer could assign its rights under the building contract to an incoming tenant. 

However, if the employer still owns the completed building, it will need to retain its rights in case it needs to claim itself in respect of defects in the works. 

Another alternative to a collateral warranty can be a letter of reliance. This is a letter giving a third party the right to rely upon a report prepared by a professional consultant, typically used in site investigations, ground condition reports, and surveys. 

These are not usually used where there is an underlying contract or appointment; there is an ongoing role in relation to the performance of services and duties or where it relates to design or construction. 

Who should give a collateral warranty?

Parties that regularly provide collateral warranties to third parties on a construction project include main contractors, consultants (usually those with responsibility for design including the architect and engineers and also those with no design responsibility, e.g. project manager) and sub-contractors (although sub-contractors with responsibility for design are more likely to provide them than non-designers).

Who should receive a collateral warranty?

Parties that frequently require collateral warranties from the construction and design team on a construction project include:

Funders - banks and other lenders funding construction works who are taking a charge over the property, rather than purchasing it, will require collateral warranties. This protects the funder if the borrower defaults under the finance agreement and the funder has to recover its loss by selling the development. The funder will require the ability to make a claim against the construction and design team if there are defects in the works that reduce the value. The funder will also require step-in rights in its collateral warranties, allowing it to step into the employer’s role in the underlying building contract and procure the completion of the development. 

Purchasers - a party that buys the development (either before or during construction as a ‘forward purchaser’ or after completion) will acquire a long-term interest in the building, even if they do not intend to occupy the building themselves, they may suffer a loss as a result of defects in the works. A purchaser will therefore require rights against the construction and design team so that they can claim against them in the event of defects arising.

Tenants - a tenant will often have a lease on a fully insuring and repairing basis. They will therefore require collateral warranties to allow them to claim against the construction and design team in the event they need to pay for the rectification of a defect. On projects where there are a number of tenants, it is usual for only those taking a lease of a substantial part of the development to receive a warranty. The obligation on the construction and design team to provide warranties to tenants is often limited to the first tenants of the property.

Employers - the employer will not require a collateral warranty from the main contractor and the consultants as it has a direct contractual link to them already by way of the building contract and professional consultant appointments. However, the employer is likely to require collateral warranties from sub-contractors engaged by the contractor. Otherwise, it cannot bring a claim against them, particularly if the main contractor becomes insolvent. In addition, where the project is procured using the design and build route, it is usual practice for the appointments of the design consultants to be novated to the contractor. As a result, the employer loses its direct contractual link to the design consultants and so will require a collateral warranty back from the novated consultants to maintain its rights against them.

There are also other parties who might also require a collateral warranty on some projects where they have an interest in the works, such as a local authority or freeholder. On large multi-let developments, the management company might require a collateral warranty, or if a tenant of an existing property is carrying out the works, the landlord may require a collateral warranty. 

Here to help

At Myerson, our Construction Team can offer advice on all aspects of contentious and non-contentious matters. We regularly advise and draft collateral warranties for construction projects on behalf of employers or third parties. For more information on the range of legal services we provide, please contact our Construction Team below.