Insolvency is a huge risk in the construction industry. What first seems like the perfect project, can quickly become the perfect storm. Sometimes, the beneficiary of a construction project can all of a sudden be left with no contractual link to project stakeholders. This is where collateral warranties come in. In this article, we’re going to discuss what collateral warranties are and the purpose they serve.
Let’s start with a definition. According to Hill Dickinson:
“a collateral warranty is a contract under which a party involved in the works warrants to a third party beneficiary that it has fulfilled its obligations under its underlying building contract, subcontract or professional appointment.”
So let’s look at an example of when collateral warranties may be used. In a typical construction project, you’ll have a client, a main contractor and subcontractors. Typically, the client has no contractual link with the subcontractors. This can be a problem, especially if a main contractor becomes insolvent. A client, may wish to hold a subcontractor accountable for work they carry out. However, with no contractual link with the subcontractors, this can very difficult. Collateral warranties provide a contractual bridge between a party to a contract and a party outside a contact (i.e., a third party). This means that if a main contractor becomes insolvent, there is an underlying agreement between the client and subcontractor. Without a collateral warranty, a third party who incurred losses, may not be able to recover them.
Now, this is an over simplification. Collateral warranties aren’t just used between clients and subcontractors. They can actually be used to bridge any gap between construction parties where there is no contractual link. For example, you may have a funder for a construction project who isn’t acting as the client or employer. They may wish to have a collateral warranties which links them to the main contractor. So what does a collateral warranty look like? It’s a contractual document, often less then 10 pages long. A draft copy is normally included in the main contract.
Collateral warranties used to be the only way that a party had obligations to a third party outside the contract. In the UK, this changed with the contract (rights of third parties) act 1999. This legislation states the following:
“(1)Subject to the provisions of this Act, a person who is not a party to a contract (a “third party”) may in his own right enforce a term of the contract if—
(a)the contract expressly provides that he may, or
(b)subject to subsection (2), the term purports to confer a benefit on him.
(2)Subsection (1)(b) does not apply if on a proper construction of the contract it appears that the parties did not intend the term to be enforceable by the third party.”
In other words, the contract only needs to state that the clauses are enforceable by a third party to become contractually obliging, rather than a separate collateral warranty agreement. However, it should be noted, the last sentence (point number 2) essentially says that the contract can include an opt out clause. This is unusual for legislation to include an opt out option. However, this is the case for this particular legislation, and it’s often found at the start of construction contracts. This legislation applies to all construction contracts concluded from 11th May 2000.