What is a collateral warranty?

What is the purpose of a collateral warranty?

Collateral warranties are often required on a construction project to create a direct contractual relationship between parties who would otherwise lack the right to enforce contract terms.

Only a party to a contract may enforce its terms, and construction projects often involve numerous stakeholders such as funders, purchasers and tenants who are not a party to the underlying works contract.  A collateral warranty is creating a contract with a third-party beneficiary (eg a funder, purchaser or tenant) who has an interest in the construction project but cannot enforce the underlying contract.   It is important to note that a collateral warranty is collateral to an underlying contract and will refer back to the obligations set out in such contract.

Employers may require a collateral warranty with parties working on the project where they do not have a direct contract in place, (eg, with subcontractors and subconsultants who have a contract with a main contractor) to ensure they have a direct contractual relationship.  This provides protection for the employer and an ability to potentially enforce contracts in the event of contractor insolvency.

Why are collateral warranties required?

• To provide a contractual link: Collateral warranties provide a direct contract between warrantors carrying out the work (eg, contractors, subcontractors, or consultants) and third party beneficiaries, (eg, funders or tenants), who have an interest in the quality and completion of the project. This enables third party beneficiaries to potentially claim against warrantors for breach of contract.
• To manage the risk in cases of insolvency: In cases where the main contractor becomes insolvent, the employer will be left without a direct contractual link to the subcontractors unless a collateral warranty is in place.  In addition, a collateral warranty may enable the employer to bypass reliance on the contractor and directly engage with subcontractors or consultants if needed if the collateral warranty contains “step- in” rights.
• To avoid reliance on negligence claims: Without a collateral warranty, the third-party beneficiary might only be able to bring a claim in negligence, which requires establishing that the warrantor owes a duty of care and can result in limited recovery.  A claim in negligence often restricts recoverable losses to physical damage or injury, meaning financial losses for rectifying defects are typically excluded.  It is considered preferable for a third-party beneficiary to have a potential breach of contract claim rather than having to rely on a negligence claim, as a collateral warranty establishes explicit terms of duty and liability making it easier for third parties to enforce contractual obligations.

What contract terms are included in a collateral warranty?

A collateral warranty is collateral to the underlying contract and a warrantor will be unlikely to want to extend its liability beyond the terms of the underlying contract.  It is therefore important to be aware of the terms of any underlying contract, as depending on the terms of a collateral warranty any limitations of liability or onerous terms of the underlying contract will affect the terms of the collateral warranty.  Regardless of this, a collateral warranty will usually include several core elements;

• Scope of Work and Standards: This will mirror the terms in the main underlying construction or sub-contract with the warrantor warranting that the underlying contract has been carried out to the required standard.
• Duty of Care in respect of design: Confirms that the warrantor owes an industry standard duty of care to the beneficiary in respect of design carried out. Again, you would expect this to mirror the terms of the underlying contract.
• Limitations on Liability: Specifies any financial caps, time limits, or other restrictions on liability.
• Copyright licence: Specifies the terms of any copyright licence granted to the third-party beneficiary in respect of any design work produced by the warrantor.
• Step-In Rights: In some cases, collateral warranties may include “step-in rights,” allowing funders or forward funding purchasers, to step into the contract in case of breach or insolvency. This allows a funder to maintain project continuity and ensure project completion if necessary.  Such provisions would also be included in a collateral warranty to an employer from a subcontractor, enabling the employer to take over the contract with the subcontractor and issue instructions to complete the works in the event of contractor insolvency.
• Insurance Obligations: Outlines the insurance requirements for the warrantor, ensuring that the beneficiary is aware adequate coverage is in place to address potential claims.
• Right of Beneficiary to assign: Allows the third-party beneficiary, such as a funder, to assign the warranty to future purchasers or other parties, ensuring the benefits of the collateral warranty are transferrable if ownership or financing changes hands.

Are there further benefits of a collateral warranty?

As detailed above, the main benefit for a beneficiary of having a collateral warranty in place is that it provides a direct contractual link where there isn’t one in the construction supply chain.  Other benefits to consider are set out below;

Protection beyond statutory rights

Some statutory protections exist, such as under the Defective Premises Act 1972, but they are often limited in scope. For instance, under this Act, only residential properties that are deemed unfit for habitation due to construction defects may qualify for claims. However, collateral warranties are not limited to residential dwellings or severe defects and can apply to commercial properties and other types of construction issues. As a result, collateral warranties extend rights and protections to a broader array of projects and stakeholders who might not benefit from statutory claims.

Greater security for investors and funders and providing the ability to “step-in”

Collateral warranties provide funders and investors with security in knowing they have a direct avenue for recourse if a project encounters quality issues or significant defects. This reassurance can help secure project financing, as lenders and investors can be more confident in the project’s long-term value and durability.

For funders, collateral warranties also allow them to pursue contractors or consultants directly if construction defects impact the property’s value, further protecting their financial interests.

A collateral warranty can also grant funders the ability to “step-in” and appoint a third party to complete the project if the current warrantor is in financial difficulty providing additional security that the project will be completed.

What happens if there is a claim under a collateral warranty?

If a party breaches a collateral warranty causing loss and/or damage the warrantor may be in a position to make a claim for breach of contract, with damages being the most common remedy. The damages awarded will depend on the nature of the breach.

It is generally recommended to try resolving the issue through negotiation or alternative dispute resolution methods before resorting to legal action.

Third Party Rights – an alternative to collateral warranties?

Collateral warranties remain a widely used solution for major construction projects due to their ability to establish clear, enforceable rights directly between involved parties and the fact that all parties generally are familiar with their use. However, providing third party rights under the Contracts (Rights of Third Parties) Act 1999 (“the Act”) may be suitable depending on the project’s specific requirements, stakeholder preferences, and risk management strategy:

What are third-party rights?

The Act was introduced with the aim of reducing the administrative burden associated with obtaining collateral warranties. The Act allows parties to a contract to grant third parties the right to enforce its terms without the need for separate collateral warranties.

For third parties to gain these rights, the contract must explicitly state that they can enforce a term.   Additionally, the third party must be clearly identified in the contract, whether by name, as a class member, or by a specific description, although they do not need to exist at the time the contract is entered into.

Rights to be granted to third parties will be set out in the main contract, with the third-party beneficiary being named or identified and with the contract containing provisions that a notice will be served granting the third-party beneficiary these agreed rights, which in practice will be similar terms to those set out in a collateral warranty.

While third-party rights and collateral warranties are similar in their effectiveness, some funders express concerns about third-party rights, particularly regarding enforceable step-in rights as these rights could impose both benefits and burdens on the beneficiary, and the Act applies only to the benefits of the contract.  However, third party rights are generally seen as an acceptable commercial alternative to collateral warranties and which option is used can be decided on a project specific basis depending on the preferences of the parties involved.

If this approach is chosen, the contract should list specific clauses enforceable by third-parties, often through a standalone schedule.

Any further considerations?

Assigning Contractual Rights

The project employer can assign its contractual rights under the building contract to a purchaser, tenant, or other stakeholders in the development. However, should the employer still own the property, assigning its rights could prevent it from enforcing claims related to defects, as it no longer holds those rights.

Due to this potential loss of control, assignment of rights is often impractical, especially when the original project employer intends to retain ownership.

Structural Insurance (Latent Defects Insurance)

Latent defects insurance covers structural issues arising after construction, generally for 10 to 12 years post-completion. This no-fault insurance protects stakeholders by covering repair costs for structural defects without requiring proof of liability against contractors or architects.

This type of insurance can be valuable, especially if the contractor becomes insolvent, as it ensures that defect-related expenses are covered regardless of other parties’ solvency. However, it has limitations. The insurance typically only covers structural damage, not non-structural defects or economic losses that arise due to those defects.

For new residential developments, NHBC “Buildmark” or similar policies cover these types of defects for 10 years. In such cases, purchasers or tenants may not need additional latent defects insurance but should understand the policy’s coverage and limitations.

Warrantors and beneficiaries

Parties likely to give collateral warranties (warrantors):

• Contractors: Contractors may give collateral warranties to third parties, such as funders, warranting that the work meets the required standards and is completed according to the contract. This also applies to subcontractors and specialist contractors who also may be required to give warranties to the employer.

• Consultants: Professional consultants, such as architects, engineers, surveyors, and other design professionals may provide collateral warranties to warrant the quality and safety of the design and consultancy work they provide.

• Suppliers: Certain suppliers, especially those who provide materials or products that are integral to the construction process (e.g., structural components), may also be required to give warranties to the employer or other interested parties regarding the quality and durability of their goods.

Parties likely to receive collateral warranties (beneficiaries):

• Employers/Developers: The employer or developer, may receive warranties from parties such as subcontractors, and sub consultants where otherwise there would be no direct contracts.

• Funders/Financiers: Banks, lenders, or other financiers backing the construction project may also require collateral warranties from contractors, consultants, and suppliers to ensure adequate security.

• Tenants/Leaseholders: If a property is being built for a specific tenant, they may request collateral warranties from contractors or consultants to protect their interests in the quality and safety of the completed building.

• Purchasers: In some cases, a purchaser of the building (especially in off-plan sales or property developments) may request collateral warranties from the contractor, or professionals involved in the construction.

If you would like to know more about collateral warranties or wish to discuss your legal requirements for an existing or forthcoming construction project, please do not hesitate to contact our dedicated team of experts in construction law.