In our experience, the purpose of a collateral warranty is often misunderstood. In this article, we explain the purpose of a collateral warranty and some key points.
What is a collateral warranty?
In the normal course of the development of a project a (for example) funder, tenant or purchaser (a “Beneficiary”) does not enter into a direct contract with a consultant (e.g. an architect or structural engineer), contractor or subcontractor (a “Service Provider”); this is usually left to a developer and/or building contractor to arrange.
A collateral warranty provides a Beneficiary with a direct contractual link with the Service Provider which would not otherwise exist. This provides a Beneficiary with additional ‘security’ should there be any issues with the progress of the works by the Service Provider or in the event of defects in the works.
Why are collateral warranties so important?
Generally speaking, a collateral warranty imposes the following obligations on a Service Provider:
- An obligation to comply with the terms of the underlying appointment (such as a building contract, subcontract or professional appointment);
- An obligation to not exercise its rights to terminate the underlying appointment without first giving the Beneficiary a certain amount of notice, during which period the Beneficiary may choose to ‘step-in’ to the employing party’s place in the underlying appointment;
- An obligation to grant the Beneficiary an intellectual property licence over the Service Provider’s drawings, calculations etc;
- An obligation to maintain professional indemnity insurance.
By way of example only, a collateral warranty allows a Beneficiary to:
- Bring a claim in contract against the Service Provider for defective works which has caused the Beneficiary a loss. The importance of being afforded the right to bring a claim in contract, as opposed to tort, is that it makes for a more straightforward claim and the ‘measure of damages’ which the Beneficiary can claim is higher in contract than it would be in tort;
- (If the Service Provider is seeking to terminate the underlying appointment as a result of a breach by the employing party (for example, non-payment of an invoice)) within an agreed period of time, step-in to the shoes of the ‘employer’ in the underlying appointment, rectify the breach and ensure that any delay to the overall project is mitigated as far as possible; this can have a significant effect on borrowing costs.
A Beneficiary will have, in all likelihood, rights in the agreement which it has signed with its developer, landlord etc. which is likely to be the Beneficiary’s first port of call in the event of a default by the Service Provider. However, if the developer, landlord etc. was to become insolvent and/or could not satisfy any damages award, then without a collateral warranty it is very difficult for a Beneficiary to recover any loss from, and/or mitigate delays in the project caused by, the Service Provider.
The importance of collateral warranties is reflected by the fact that many contracts now make payment conditional on all collateral warranties having been executed and returned.
Risks associated with collateral warranties
The benefit of a collateral warranty from a Beneficiary’s perspective is clear and poses no risk to the Beneficiary unless the Beneficiary uses its step-in rights.
From a Service Provider’s perspective, the risk usually outweighs the benefit. In reality, the only real benefit for a Service Provider is that a Beneficiary may step-in to the underlying appointment in the event of a breach by the ‘employing party’ and continue to pay a Service Provider; beyond this, a collateral warranty is mainly risk for a Service Provider. In some cases, a Service Provider may not see step-in rights as a ‘benefit’ as it does not want a Beneficiary to step-in and become its employer for a number of reasons, such as the Beneficiary’s own solvency and commercial interests etc.
Any collateral warranty provided by a Service Provider increases a Service Provider’s risk, as a Service Provider is allowing a Beneficiary the right to bring a claim against it which a Beneficiary may not otherwise have. It is therefore very important that before providing a collateral warranty a Service Provider:
- Checks that its contract with its employer obliges the Service Provider to provide a collateral warranty to that Beneficiary (or any Beneficiary); and
- Carefully checks the terms of the collateral warranty.
In terms of checking the collateral warranty, there are a number of key points to look out for (please note that this is not an exhaustive list):
- The terms of the collateral warranty should not be more onerous than the terms of the underlying contract to which it relates (e.g. a subcontractor’s collateral warranty should not contain terms which are more onerous than those in the subcontract);
- Does the collateral warranty contain step-in rights and is the Service Provider obliged to agree to step-in rights? If not, is granting step-in rights in relation to that particular Beneficiary on a commercial level a good or bad decision?
- Can the collateral warranty be assigned? If so, to whom and on how many occasions? If a warranty can be assigned without limitation then this can create uncertainty as to which party can bring a claim against the Service Provider via the collateral warranty.
- Is there a ‘no greater liability’ clause in the warranty which ensures that the Service Provider does not owe a greater liability to the Beneficiary under the warranty than it does to its employer under the underlying contract? Such a clause would capture any cap on liability etc. in the underlying contract which has not been included in the collateral warranty.
How we can help
We provide a fixed-fee collateral warranty review service. If you would like more information regarding this service or regarding collateral warranties in general, then please contact a member of our Construction & Engineering team on 01332 340 211.