Collateral warranties – how far can they go?
Whether you are an employer, a contractor, sub-contractor or consultant you are likely to have been a party to a collateral warranty at some stage. You may have been the beneficiary or the warrantor. Either way, you should carefully check the terms and extent of the warranty you are giving or receiving. This issue came up recently in relation to a collateral warranty entered into between an employer and a sub-contractor. The collateral warranty seemed to impose greater obligations on the sub-contractor than the sub-contractor had assumed under its sub-contract.
The collateral warranty included none of the express exclusions of liability that appeared in the sub-contract and did not contain any "equivalent rights of defence" or "no greater liability" clauses. It was otherwise in what could be described as a standard market form and included no express provisions which limited it in any way by reference to the terms of the underlying sub-contract.
In the event that there were defects for which the sub-contractor was liable, was it possible that the sub-contractor could have greater liability under the collateral warranty than it had under its sub-contract?
Starting point – purpose of collateral warranties
Defective design or workmanship by a consultant, contractor or sub-contractor can cause loss to many parties with different interests in a construction project. Due to the way in which risk is filtered down through the supply chain, there is usually no direct contractual link between an employer and a specialist consultant or sub-contractor or between third parties such as tenants, purchasers and funders and the main contractor, sub-contractors or consultants. Despite the option of rights granted under the Contracts (Rights of Third Parties) Act 1999, entering into collateral warranties remains a popular means of establishing this link.
Collateral warranties in the construction market
Various industry bodies produce a standard form of collateral warranty for use on construction projects and many are produced on a project specific basis. They often assume a similar form and structure with the intention of creating privity of contract between the warrantor and beneficiary which would otherwise not exist.
In respect of such collateral warranties, Keating, a leading textbook on construction law, states:
"The word 'collateral' imports that the contract is subsidiary to a main or principal contract. The word 'warranty' in this context means 'enforceable contractual promise' and in substance means the same as 'contract'. These contracts have in law all the manifestations and requirements of ordinary contracts and in principle they have no special features."
This suggests that collateral warranties are contracts in their own right. While the name "collateral" implies subordination to the main building or sub-contract, it is still a separate contract on which the beneficiary may rely.
In Parkwood Leisure Ltd v Laing O’Rourke Wales and West Ltd a collateral warranty was found to be a "construction contract" within the meaning of section 104(1) of the Construction Act 1996. The court reached this conclusion on an analysis of the terms of the collateral warranty in question. Without re-opening the arguments for and against Akenhead J's analysis and the effect of his conclusion, the decision supports the potentially stand alone nature of the collateral warranty.
No greater liability clauses
The warrantor will be reluctant to accept more extensive obligations under the collateral warranty that may extend its liability to third parties. On the other hand, the beneficiary will want to make sure that the warrantor cannot avoid liability under the collateral warranty. The compromise is to mirror, so far as possible, the terms of the underlying contract.
Including "equivalent rights of defence" and "no greater liability" clauses confirms the parties' intention that the warrantor's liability under the collateral warranty is not greater (but also not less) than it assumes under the main contract. It is market practice to include such clauses. However, there are circumstances in which the warrantor may assume additional obligations or duties, for example in relation to a funder's step-in rights, or perhaps in respect of very specialist works with regard to a particular beneficiary. More limited obligations may also be assumed, such as in tenants’ collateral warranties limiting liability to repair and reinstatement costs.
This suggests that collateral warranties are stand alone contracts that must be expressly limited. Presumably, "no greater liability" type clauses must exist for a reason or are they implicit and expressly included only as a precaution and to avoid disputes?
Back to basics
Unfortunately, there doesn't seem to be any express authority on these issues and the extent to which a contractor's liability under a collateral warranty may exceed its liability under the main contract.
If we are to return to the rationale behind collateral warranties, it can be said they operate as a back-up for employers, providing a new or extra layer of protection against key sub-contractors should defects arise in their works, in particular if the main contractor has become insolvent. This is not to imply that the main contractor can be "off the hook", rather that someone else can be on it.
However, for "true" third parties, such as purchasers, tenants and funders, the collateral warranty provides the primary means by which they can seek to recover any losses they may have suffered directly from the party who caused the loss, in circumstances where they would otherwise have to pursue a claim for economic loss in tort, with all the difficulties that this presents. This is the primary rationale behind collateral warranties, particularly when they are employed instead of statutory third party rights. They create a contractual relationship in circumstances where one would not ordinarily exist.
It seems logical that a collateral warranty, which is a separate contract, can impose greater liability on the warrantor than it assumes under the underlying contract. However, beware of representations which may have been made to induce the warrantor to enter into the collateral warranty, in particular if the collateral warranty does not include an entire agreement clause. Has an assurance been given to the warrantor that the collateral warranty is limited in some way, perhaps by reference to the terms of the underlying contract? One would expect the warrantor to insist on some limitation in the collateral warranty along these lines. In those circumstances a beneficiary may find itself estopped from enforcing the "unlimited" collateral warranty if the warrantor was induced to enter it on the basis of such a representation.
Like any contract, it all comes down to the contract terms. If there is nothing in the express terms of the collateral warranty which limits it, then it is a question of what representations may have been made, what terms may be impliedinto it and the usual limitations in terms of recovering damages at common law to which the collateral warranty will be subject, such as remoteness of loss and equitable principles.
A version of this article was first published by Practical Law Construction on 19 July 2019.
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