Collateral warranties – what are they are and what to look out for

Collateral warranties are secondary contracts that provide an interested third party with contractual rights against the service provider to a primary contract. Under the collateral warranty, the third party is known as the beneficiary and the service provider is the warrantor.

To demonstrate a working example, the parties to a typical project might include the funder, employer (or client), main contractor, design consultants, subcontractors and material suppliers. One primary contract would be that between the main contractor and its mechanical and electrical (“M&E”) subcontractor. However, the employer, which will be inheriting the completed building, will have an interest in the operation of the completed M&E installation. In the current scenario, if the employer found defects in the M&E installation after practical completion, it would have to issue a claim against the contractor who would then in turn claim against the M&E subcontractor. This is however both time-consuming and costly for the employer. Alternatively, if the employer had entered into a collateral warranty with the M&E subcontractor it could make a direct claim against it to recover the losses caused by the defects.

Collateral warranties can also be used to provide a beneficiary with security for performance of the primary contract. For example, there is a primary contract between the employer and contractor. The funder will have an interest in the project completing and subsequently recovering its investment. Therefore, a collateral warranty between the funder and contractor would allow the funder to “step in” and oversee the completion of the construction works in the event of the employer’s insolvency.

Key features to look for

Service providers such as contractors, subcontractors and design consultants are often asked to enter into collateral warranties. Service providers are reminded that collateral warranties are generally for the benefit of the beneficiary which will be keen to gain a broad range of rights for a potential claim.

The list below provides a non-exhaustive list of key features that service providers should look for when reviewing a collateral warranty to ensure that they are not exposed to unnecessary risk.

  1. Is entering into the collateral warranty a contractual obligation? Often parties will be asked to enter into collateral warranties during the works or after practical completion. If entering into that collateral warranty was not agreed to before the contract was executed there is no obligation for the service provider to do so. If entering into the collateral warranty is a contractual obligation the service provider should review the document when formulating its tender and cost any risks accordingly.
  2. Limit of liability. Primary contracts will sometimes include a monetary limit on the service provider’s liability in the event of a claim (or series of claims) against it. The service provider should check that this limit is mirrored in any collateral warranty by a “no greater liability” provision.
  3. Limitation period for claims. Under English law, the limitation period for making a contractual claim is 6 to 12 years (depending on whether the contract was executed as a deed). On construction contracts the limitation period usually starts on practical completion of the works. The service provider should check that the limitation period and start date in the collateral warranty mirrors that of the primary contract to ensure that it is not exposed to potential claims beyond the limitation period in the primary contract.
  4. Standard of duty. Most primary contracts will oblige the service provider to carry out its duties with “reasonable care and skill” (for example, see clause 2.1.1 of the JCT D&B 2016 contract). The service provider should check that this standard is mirrored in any collateral warranty and not inflated to the higher “fitness for purpose” standard.
  5. Copyright. Some collateral warranties will seek a copyright licence in favour of the beneficiary, so that it can use the service provider’s documents in relation to the project. This could include using a structural engineer’s design as part of an extension project. The service provider may wish to stipulate the limits on the use of its material or insist that granting such a licence is contingent on payment in full under the primary contract.

Conclusion

This note has set out what collateral warranties are and the key features that contractors, subcontractors and design consultants should look for when reviewing them. Collateral warranties are however complex documents which could expose the service provider to unnecessary risks. Service providers should therefore seek advice when reviewing collateral warranties in order to both comprehend the potential risks and cost them accordingly.

Expert
Liam Hendry
Solicitor