What are collateral warranties and why are they needed?

Collateral warranties have been a common feature of building and engineering projects for many years now, yet to many they remain a mystery.  There are many legal and commercial rationales for collateral warranties, which can be summarised as:

• Marketability of the project – if a robust collateral warranty package is not in place then this can lead tenants and purchasers to seek other commercial concessions.  Similarly providers of funding for projects or for the purchase of a building will generally expect a full package of collateral warranties, the absence of which will hamper the developer's or purchaser's ability to get funding;
  
• A clear copyright licence to use and reproduce drawings, specifications and other documents produced by the construction team for the project and the site;
  
• Recourse for any defects in the design and/or the construction of the project; and
  
• Step in rights which will give the beneficiary of a collateral warranty the option to "take over" the underlying building contract, sub-contract or professional appointment to which the collateral warranty relates.

A collateral warranty is a contract entered into between a granter (a contractor, a professional consultant or a sub-contractor) and a beneficiary who has an interest in the project or in the land on which the project is carried out.  The collateral warranty will create a direct contractual link between the granter and the beneficiary so that the beneficiary can rely on the work of, and have recourse to, the granter (or its professional indemnity insurer to the extent applicable) if there is an issue with that work.  There are other common features of collateral warranties, such as copyright licences and step in rights, which are considered below.

They are "collateral" because they are ancillary to the main contract to which they relate (be that a building contract, a sub-contract or a professional appointment); and they are "warranties" because they contain direct confirmations and assurances to the beneficiary that the granter has complied or will comply with its duties and obligations under the building contract, sub-contract or professional appointment.

Beyond the commercial reasons for collateral warranties, they are required because the general law does not, except in very limited circumstances, impose a duty of care on construction contractors, consultants and sub-contractors to any party who is not their direct employer nor does the law provide third parties with a copyright licence or the right to step in.  So, for example, without a collateral warranty, an employer/client cannot sue a sub-contractor for defective work; a funder of the project cannot sue the main contractor; and a purchaser or a tenant of commercial property cannot sue the construction team.  All of these parties could suffer a loss if there is a failure on the part of the construction team leading to a defect in the completed project.

We have seen an increased focus on the rights and remedies available to parties under their collateral warranties since the outset of the recession, whereas previously defective works or design were sometimes "overlooked" due to rising property prices and returns (which is a point illustrated below in the White Property case). 

Collateral warranties are usually only relevant for the first 10 to 12 years after construction has been carried out because (i) claims under collateral warranties are usually subject to time limits of up to 12 years after practical completion (handover) of the construction works; and (ii) it becomes increasingly difficult to prove a claim as time passes by due to a lack of records (such as design documentation, project correspondence and meeting minutes) or access to relevant personnel who were involved in the construction works.  In addition normal wear and tear or misuse of the building can obscure the assessment of the responsibility of the original construction team.  Nevertheless, we have been involved in raising actions under collateral warranties several years after construction was completed.

Who gets collateral warranties?

Typically collateral warranties are required by:

• Employers/clients - from sub-contractors, sub-consultants and on novation of design consultants if the design team is transferred to the contractor where the employer wants to place "single point responsibility" for design and construction on the contractor (this is called "novation");
• Providers of finance for a project;
• Purchasers of completed projects;
• Providers of finance to purchasers; and
• Tenants of commercial property where the tenant is responsible for the repair and insurance of the leased premises and will therefore want to be able to look to the construction team if a problem arises with the design or construction of the premises during the lifetime of the collateral warranty.

In some cases other parties might require collateral warranties to be granted in their favour.  This might be the owner of the site if it is not the party carrying out the project (e.g. the landlord in relation to a complex fit-out) or adjoining proprietors whose property could be affected by construction work and whose consent might be required to allow the project to proceed.

Employers/clients in commercial property projects will want to ensure that they have suitable obligations on the construction team to grant collateral warranties to purchasers, tenants and funders.  If not this will detract from the "marketability" of their development, as tenants, purchasers and funders will generally look for a full package of collateral warranties to be available.  Indeed , in White Property Company Limited v Birse Construction Limited, a developer raised a claim against the contractor because the contractor had failed to grant collateral warranties and procure sub-contractor collateral warranties for a shopping centre on the basis of a dispute that had arisen between the parties.  The property was valued at £45 million, which represented a £2.5 million diminution in value.  The court found that the developer's loss had been mitigated to such an extent that that the loss was extinguished, in light of the capital appreciation of the building and the rental income that the developer had received during its longer than anticipated ownership of the centre.  This case was decided about 10 years ago – given the impact of the recent recession, a developer in a similar situation today may not have the benefit of capital appreciation and rental income, and so there may well be a different result if a similar case came to court.

What is normally covered in collateral warranties?

Collateral warranties may originate as lawyers' or surveyors' individual style documentation or as standard forms published by industry bodies (e.g. Joint Contracts Tribunal/Scottish Building Contracts Committee or the Construction Industry Council).  Regardless of the origin of the collateral warranty, beneficiaries of collateral warranties will want to make sure that collateral warranties include:

• A duty of care undertaking whereby the granter confirms that it has complied with its obligations in the building contract, sub-contract or professional appointment and that the granter has exercised the level of reasonable skill and care to be expected of its peers in relation to any professional services (be that design, cost advice, project management, contract administration or health and safety advice).  It is crucial to note that the value of any collateral warranty, no matter how robust, is dependent on the terms of the underlying contract to which it relates, because (i) the granter will only give warranties in relation to the obligations that appear in the building contract, sub-contract or professional appointment; and (ii) any caps on liability or exclusions of liability in the building contract, sub-contract or professional appointment will in most cases also apply to the recourse available to the beneficiary under the associated collateral warranty.  It is not, therefore, possible to properly assess the value of a collateral warranty without reviewing that underlying contract. 
• A copyright licence allowing the beneficiary to copy and use drawings, specifications, bills of quantities and other project documents in relation to the project and the completed project.  A copyright licence might be required for a wide variety of reasons such as to allow a tenant to integrate its fits out into shell and core works, to allow the employer/client to market the property for sale or lease or to allow a purchaser to maintain the health and safety file for the property. 
• An undertaking to maintain professional indemnity insurance for a specified amount and time, where the granter has some element of professional responsibility in relation to design or other professional services.  Although professional indemnity insurance is designed primarily to protect the insured party, purchasers, tenants and funders will want to have certainty that insurance is in place, particularly in the context of professional consultants whose only assets might be a lease and their office equipment. 
• The right to assign the benefit of the collateral warranty.  It is almost always the case that warranties are only granted to first funders, first purchasers and first tenants so provision is made for the collateral warranty to be assigned to second purchasers, their funders and to tenants.  It is fairly standard for collateral warranties to be assignable on two occasions without consent.  Prior to the credit crunch, given the speed at which property changed hands, it was often the case that all the assignations had been used up before the expiry of the collateral warranty.
• Step in rights for employers and funders to allow them to "take over" the contract to which the collateral warranty relates.  In the case of an employer, if the main contractor it has engaged becomes insolvent or simply fails to perform, the employer might want to "step into" the contracts with the key sub-contractors in order to finish the works.  In the case of a project funder, if the developer disappears, the funder might want to have the ability to step in and complete the project to protect the value of its security.  Step in rights are optional and it may be that the beneficiary chooses not to complete the project because the cost of paying all outstanding liabilities outweighs the return that can be made.  However, in one case earlier this year (The Royal Bank of Scotland Plc v Chandra [2010] EWHC 105 (Ch)), the Bank, in fact, obliged itself to step in to the building contract.  This is extremely unusual but arose from the fact that the contractor was concerned about the ability of the developer to meet its obligations.  The contractor, the developer and the bank therefore agreed that the contractor would have the benefit of mandatory step in rights to give the contractor security in the event of developer default or insolvency.

Consultants, contractors and sub-contractors granting collateral warranties will wish to make sure that the collateral warranties they grant:

• are clear that they have the protection of any caps on, or exclusions of, liability in the building contract or professional appointment should a claim arise under the collateral warranty;
• include any additional caps or exclusions to apply in the collateral warranty.  An example is a "net contribution" / "fair share" clause that apportions liability for a fault on the assumption that all other parties at fault have paid their share of the beneficiary's loss.  Funders will generally not accept such clauses but they are sometimes a feature of tenant collateral warranties;
• have a time limit on liability;
  include the right to rely on the same defences to claims under the collateral warranty that they would have against their client/employer; and
• incorporate an ability to maintain a lower level of professional indemnity insurance should the cost of policies become prohibitively expensive.

Are there alternatives to collateral warranties?

If dealing with a multi-occupancy building where there is a requirement for collateral warranties in favour of the employer/client, funders, purchasers and dozens of tenants then several hundred collateral warranties may be required to satisfy all parties.  This is clearly an exercise that, whilst largely administrative, could have a significant cost and time impact.  For that reason parties often look to consider alternatives to collateral warranties, such as:

• Assignment/Assignation:  The employer/client could assign the benefit of the construction contracts, however this can only provide a benefit to one party and might not be appropriate where the employer/client has ongoing obligations to purchaser or tenants to procure that defects are made good during the defects liability period or to the contractor to release the retention following completion of making good defects.  Assignments or assignations are also not generally favoured because the assignee can acquire no better rights than the assignor has, and so any settlements reached with the construction team could defeat the assignee's claim.  In many cases the assignee will be completely unaware of the terms of any settlement between the assignor and the construction team and therefore the impact on the rights that are being assigned.
• Third party rights:  Whilst there is legislation in England which allows parties to a contract to agree to benefit third parties who are not party to the contract (e.g. funders, purchasers and tenants) and a third party rights principle in Scotland called the jus quaesitium tertio, for a variety of reasons third party rights have tended not to be used nearly as much as collateral warranties.  Nevertheless, the suite of standard form construction contracts published by the Joint Contracts Tribunal for use in England and Wales and their Scottish equivalents produced by the Scottish Building Contracts Committee does include a third party rights option.
• Latent defects policy:  A latent defects policy is an insurance product that will respond to certain latent defects in buildings.  Although these policies do provide insurance based protection, they are not generally seen as a replacement for collateral warranties because any claims made are subject to a deductible or excess; liability is capped at the sum insured, is subject to the exclusions in the cover provided (often excluding consequential losses and mechanical and electrical elements of the building) and is dependent on the general issues surrounding insurance contracts including disclosures made at the time the policy was obtained.  In the case of a party who is purchasing a property who wishes to rely on the transfer of an existing insurance policy (e.g. by endorsement or assignment/assignation of rights), it will not have made those disclosures and may not have access to the facts or documentation to allow it to assess whether there is any issue with the disclosures made for the purposes of obtaining the policy.  Latent defects insurance policies will also not provide the other benefits of collateral warranties noted above, e.g. step in rights and  a copyright licence.

Conclusion

The possible alternative comfort options outlined above have not succeeded in replacing the need for collateral warranties, which will remain a key feature of construction and engineering projects for the foreseeable future.

Although there are common provisions in collateral warranties, each style is different and should be carefully reviewed, together with the underlying construction contract, to make sure that it provides sufficient comfort for the beneficiary, or that it does not go too far from the granter's perspective.