A collateral warranty is a contract that is collateral to or stands alongside the principal or underlying contract (such as the construction contract or consultant’s appointment). The majority of collateral warranties refer to the responsibilities and obligations outlined in the underlying contract, and the warrantor declares to the third party that it has fulfilled these duties and obligations in accordance with the contract. JCT, The Joint Contracts Tribunal, is the body who produces a suite of building contracts for use as a standard industry form. In this article, collateral warranties JCT, we take a look at the process involved and the options available to you.
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What is the purpose of a Collateral Warranty?
In a straightforward construction project, an employer may hire a contractor to complete the work. Usually, these two parties have a contractual relationship.
However, construction projects invariably involve a number of parties with a vested interest in the development (such as lenders, buyers, and renters), in addition to those performing the actual labour (contractors and consultants). Some of these parties will have neither a contractual nor a business relationship.
Generally speaking, only parties to a contract may enforce its terms. If a subcontractor breached its subcontract (with the contractor) and that breach had a detrimental impact on the employer (or a funder/purchaser or renter), the employer could not enforce the agreement. This is difficult for the employer, especially if the prime contractor is bankrupt.
Moreover, if the employer discovers defects in the subcontract works, the employer would have no contractual recourse against any of the parties involved in the absence of a collateral warranty. Without this contractual relationship, the employer would be forced to depend on a claim of negligence. Before evaluating the claim, the employer would be forced to demonstrate that the subcontractor owed it a duty of care, which is undesirable. Even if successful, the employer would be unable to recoup damages for negligence.
The goal of collateral warranties is to bridge the gap between contracts and provide a direct contractual link for the advantage of parties with no other recourse.
Who should provide a collateral warranty?
It may be advantageous to require that the General Contractor issue warranties to, for example, the Funder and future purchasers and tenants. For funders, this may be a condition of the funding agreement; for purchasers and tenants, this may raise the value of the asset they are purchasing, as they would have direct recourse to the General Contractor for any difficulties that may arise with the building during their ownership or occupancy.
When design is performed by specialised subcontractors, it might be prudent to establish a direct contractual link via a collateral warranty.
Who should obtain a collateral guarantee?
The following parties usually demand collateral warranties from the construction and design team on construction projects:
Funders – banks and other lenders funding construction projects by taking a lien instead of purchasing the property – will require collateral warranties. This safeguards the lender in the event that the borrower defaults on the financing agreement and the lender is forced to sell the development to recoup losses. The funder must be allowed to pursue a claim against the construction and design team if construction defects reduce the value of the project. In order to assume the employer’s position in the underlying construction contract and secure the development’s completion, the funder will also need step-in rights in its collateral warranties.
Purchasers – A party that buys the development (either before or during construction as a “forward purchaser” or after completion) will obtain a long-term interest in the building, even if they do not intend to occupy it themselves; they may incur a loss owing to defects in the works. Consequently, a buyer will demand rights against the construction and design team in order to file a lawsuit against them if faults occur.
A tenant will normally have a lease that is fully repairing and insuring. Consequently, they will require collateral warranties to enable them to submit a claim against the construction and design team if they are required to pay for the remedy of a problem. On projects with several tenants, a warranty is often extended only to those who lease a substantial piece of the development. Typically, the building and design team’s obligation to give warranties is limited to the initial inhabitants.
Employers – Since the employer already has a direct contractual relationship with the general contractor and the consultants through the construction contract and professional consultant appointments, the employer will not require a collateral warranty from them. However, the employer would certainly require further warranties from the contractor’s subcontractors. Aside from that, it cannot assert a claim against them, particularly if the major contractor declares bankruptcy. In addition, when a project is acquired using the design-and-build technique, it is typical to novate the design consultant appointments to the contractor. To preserve its rights against the novated consultants, the employer will require a collateral guarantee from the consultants.
If they have a stake in the project, other parties, such as a local authority or freeholder, may also seek a collateral warranty. On big multitenant complexes, the management firm may require a collateral warranty, and if a tenant performing improvements on an existing property, the landlord may require a collateral warranty.
Step-In Rights
Some collateral warranties may also include ‘step-in’ rights, which permit the beneficiary to assume control of the underlying contract and provide instructions.
If there is no contractual agreement, the subcontractor is not required to accept instructions from the employer to complete the job in the event that the project’s prime contractor becomes insolvent. The adoption of a collateral warranty in this circumstance creates a direct contractual link that enables the employer to offer instructions to the subcontractor, so assuring that the subcontractor fulfils its duties.
Will a standard form JCT Collateral Warranty be good enough?
Standard forms of collateral warranty are available, although custom forms created by solicitors are popular. It is preferable to have a warranty form that offers the essential contractual duties rather than attempting to impose onerous or unrealistic forms, which will necessitate lengthy negotiations and function as a barrier to executing warranties, which is ultimately unproductive.
Typically, the collateral warranty should not impose a higher obligation on the provider than the underlying agreement.
Is there an alternative to a collateral warranty?
The Contract (Rights of Third Parties) Act 1999 can be used as an alternative to collateral warranties as it enables third party rights to be created by a contract, however, collateral warranties tend to be the preferred option of creating the direct contractual relationship at the present time.
What are the risks of not having collateral warranties?
The primary risk associated with the absence of a collateral guarantee is that reliance must be placed on the contractual ties that are currently in place – the Main Contract and the Subcontractors. Collateral guarantees should be viewed as part of a project’s security package — provided that the Main Contract and its supply chain continue to trade, there is no reason to view them as “essential” – perhaps “desirable” is a more accurate term.
There is no reason why collateral warranties cannot be requested retrospectively, but the contractor would be under no duty to deliver them, and it would not be out of the ordinary for a monetary value to be attached to their provision under such circumstances. This is reasonable given that the Contractor is providing the warrantee with a benefit, namely the opportunity to pursue him directly for a remedy in the event of problems with the building or warranted work.
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Disclaimer: This article provides general information only and does not constitute legal advice on any individual circumstances.
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