Collateral Warranties or Third Party Rights?

Privity of contract

A construction project involves many parties with different interests in the completed project. Some parties will enter into formal written contracts with one another. For example, the employer will usually enter into contracts with its contractor and professional team.

However, other parties with an interest in the new building will not enter into direct contracts with those designing and constructing the project. For example, the typical tenant, buyer and funder of a completed project will not appoint the design team or contractor.

These interested parties will not want to be left out of pocket if defects in the project have a detrimental effect on both the capital value and ongoing running cost of the project. A funder, buyer or employer may be most concerned by a reduction in the capital value of their asset, while a tenant of a commercial building may be concerned about higher ongoing running costs or its repair obligations under an FRI lease.

If a professional consultant or a contractor makes a mistake during design or construction, resulting in a defect in the completed works, a buyer, tenant or funder may suffer a loss.

You might think the buyer, tenant or funder could seek to recover its loss by making a claim against the party responsible for the defect in contract or in tort.

Contractual claims

However, the rule of privity of contract applies to contractual claims.  Privity of contract is a common law doctrine which prevents a person who is not a party to a contract from enforcing a term of that contract.

This means that a buyer, tenant or funder will not be able to make a claim under the relevant professional appointment or building contract.

There is an exception to this rule, which we will consider later.

Claims in tort

Tort is the branch of law that imposes civil liability for breach of obligations imposed by law, as opposed to contractual obligations.  In construction the tort of negligence arises most often.

However, English law has developed so that it is usually difficult or impossible for a buyer, tenant or funder to recover their financial losses (such as the cost of repairs) using a tortious claim.

In the leading case of Murphy v Brentwood District Council, the House of Lords held that a local authority was not liable in tort for negligent application of the building regulations, where the resulting defects are discovered before physical injury occurs as the loss suffered is purely economic.

In 1970, the claimant bought one of a pair of houses built on a concrete raft foundation on an in-fill site. The raft was defective and differential settlement occurred. The claimant was unable to repair the defect, and sold the house, sustaining a loss of £35,000. He sued the council for negligent approval of the plans, claiming that there had been an imminent risk to health and safety from fractured gas and oil pipes.

The House of Lords held, that the loss suffered was economic loss and the council were not liable in tort for negligent application of the building regulations where resulting defects had not caused physical injury

Lord Bridge:

“If a builder erects a structure containing a latent defect which renders it dangerous to persons or property, he will be liable in tort for injury to persons or damage to property resulting from that dangerous defect.

But if the defect becomes apparent before any injury or damage has been caused, the loss sustained by the building owner is purely economic.

If the defect can be repaired at economic cost, that is the measure of the loss. If the building cannot be repaired, it may have to be abandoned as unfit for occupation and therefore valueless.

These economic losses are recoverable if they flow from breach of a relevant contractual duty, but, here again, in the absence of a special relationship of proximity they are not recoverable in tort.”

Collateral warranties to the rescue

A collateral warranty is a contract between a person with an interest in the project (the beneficiary) and a person who was involved in the project’s design, management or construction.

The consultant and/or building contractor usually warrants to the beneficiary that it has complied with the terms of its professional appointment or building contract.

The developer may also wish to obtain collateral warranties for its own benefit from the sub-contractors and any novated consultants in case the contractor becomes insolvent.

In practice, construction projects tend to feature many more parties and many more collateral warranties.

If the beneficiary has collateral warranties then it may be able to recover its losses in the event of any defects. The buyer must show that the relevant consultant, contractor or sub-contractor:

• breached the terms of the collateral warranty; and
• this breach caused the beneficiary to suffer loss.

The extent of recovery is often affected by common limitations in the collateral warranties.

Common Beneficiaries of a Collateral Warranty

It is best practice to agree, in the professional appointment or building contract:

• who will be given a collateral warranty; and
• what form of collateral warranty will be provided

An attempt to agree an appropriate form of collateral warranty and list of beneficiaries after signing can be time-consuming and may reach a stalemate. Having agreed a professional appointment or building contract, a contractor or professional consultant may not be willing to extend its liabilities to third parties, unless the employer makes this requirement clear from the beginning of negotiations.

Professional appointments and building contracts commonly require a collateral warranty to be given to:

• A buyer of all or part of the completed project;
• A tenant of all or part of the completed project; and/or
• The employer’s funder of the construction phase of a project.

Additionally, on a larger project, some professional appointments and building contracts may require a collateral warranty to be given to:

• A funder of any stage of the project and a funder of a buyer of the completed project;
• The employer, after a professional appointment is novated to a design and build contractor;
• A management company of the completed project;
• A group company, in the same group of companies as the employer;
• A joint venture partner;
• The operator of a completed facility; and/or
• The sponsor (also known as the procuring authority) of a PPP project.

On a larger project, the employer may expect sub-contractors or sub-consultants to provide collateral warranties to the employer and, in some instances, additionally to buyers, tenants and the funder. As a possible middle ground, the employer may require sub-contractor and sub-consultant collateral warranties only from those with a key design or construction responsibility.

Any beneficiary of a collateral warranty should have an interest in the project or the completed project. If a beneficiary does not need step-in rights or will not suffer a loss if the professional consultant or contractor breaches its appointment or building contract, there is no practical benefit to the beneficiary having a collateral warranty.

Common Features of a Collateral Warranty

Key clauses in collateral warranties

A collateral warranty in favour of a buyer or tenant of a commercial property development typically includes certain core features, many of which are common across all construction and engineering sectors.

 A collateral warranty in favour of an employer or funder is typically slightly different to a buyer or tenant collateral warranty.

A collateral warranty in favour of a buyer or tenant of a commercial property development usually includes clauses that:

• Require the warrantor to comply with the professional appointment or building contract it entered into with the developer. Additionally, where the warrantor has a design responsibility, some collateral warranties include an obligation to both comply with the professional appointment or building contract and an obligation to exercise skill, care and diligence in carrying out design;
• Confirm that the beneficiary may appoint others to inspect the project, without affecting the warrantor’s obligations under the collateral warranty;
• Grant a copyright licence (or wider intellectual property licence) in favour of the beneficiary, allowing it to copy documents and designs for use in connection with the project;
• Oblige the warrantor to maintain professional indemnity insurance (often for 12 years from practical completion), provided that the warrantor has a design or management obligation;
• Limit the beneficiary’s right to assign the benefit of the collateral warranty;
• A right to assign the benefit of the collateral warranty to a person taking the beneficiary’s interest in the project on two occasions is common. Assignment on two occasions is a generally accepted balance between a beneficiary’s desire for flexibility and freedom of assignment and the warrantor’s concern that it may be exposed to claims from many different parties; and
• Step-in rights allow a funder to take over the employer's role on a project if the employer is insolvent or does not comply with the professional appointment or building contract.

Any collateral warranty should be drafted consistently with the professional appointment or building contract to which it relates.

Key limitations in collateral warranties

A collateral warranty usually includes a “no greater duty” and/or an “equivalent rights of defence” clause:

• A no greater duty clause says that the consultant or contractor cannot owe the beneficiary greater duties under the collateral warranty than it would owe the employer under the professional appointment or building contract.
• An equivalent rights of defence clause says that the warrantor may use any defence under the professional appointment or building contract (which it would have against the employer) to defend a claim from the beneficiary under the collateral warranty.

Most collateral warranties include a clause limiting the period during which the beneficiary may make a claim against the warrantor to (often) a period of 12 years from practical completion.

Depending on the nature of the project and the relative bargaining positions of the parties, other limitations may include:

• A net contribution clause, limiting the liability of the warrantor to a “fair and reasonable” or “just and equitable” amount
• A limit on the types of loss that the beneficiary may recover. A beneficiary may only be entitled to claim the losses that are “the reasonable costs of repair, renewal and/or reinstatement”.

Section 1 of the Third Party Rights Act 1999

Section 1(1) of the Third Party Rights Act 1999 allows the parties to a contract to grant a third party the right to enforce a term of that contract:

"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-

• the contract expressly provides that he may, or
• subject to subsection (2), the term purports to confer a benefit on him."

Third party rights allow a third party to enforce a term or terms of a professional appointment, building contract or sub-contract, that otherwise the third party could not enforce.

Two Common Methods of Drafting Construction Third Party Rights

Practitioners have generally adopted one of two methods for drafting construction third party rights:

• stand-alone schedule of third party rights (perhaps most common)
• a schedule identifying those clauses in the underlying contract that a third party may enforce

Funders’ Third Party Rights and Step in Rights

Because third party rights can only be used to give a funder rights, the parties should avoid including forms of step-in right that place obligations on the funder.

The funder will need to pay the affected professional consultant or building contractor after stepping in. On the face of it, this is an obligation, not a right. However, one possible solution is to use a condition precedent to a step-in by a funder, making the funder's ability to exercise its rights conditional on it undertaking to pay the affected professional consultant or building contractor.

JCT Third Party Rights

One of the other commonly used and well-known examples of third party rights in construction is in the 2011 and 2016 editions of the JCT Standard Building Contracts. The JCT uses a schedule of rights, included at Schedule 5 to the Standard Building Contracts.

Other Example Third Party Rights

Some construction solicitors have developed and use their own bespoke schedules of third party rights in building contracts and professional appointments. There is no universal form of third party rights and, while some forms of professional appointment now include the use of third party rights, those published by representative bodies of professional consultants have not yet included such rights.

For example, the form for architects published by the Royal Institute of British Architects (RIBA) does not include third party rights unless an online-only version, draft schedule is adopted (the schedule forms part of the electronic versions of the Standard Conditions of Appointment for an Architect, 2010 edition, including its 2012 revision).

Why not use Third Party Rights?

The parties may choose to use a collateral warranty rather than using the Third Party Rights Act 1999 because:

• The construction industry is familiar with collateral warranties;
• A collateral warranty is a separate contract between the parties to the collateral warranty. While collateral warranty is collateral to, for example, a professional appointment, it is a contract in its own right. It may be enforced and its benefit may be assigned on the terms set out in the collateral warranty;
• Unfortunately, current experience indicates that many sub-contractors are unfamiliar with third party rights. This means that including such provisions in a sub-contract often requires extra explanation and negotiation, which is time-consuming and expensive;
• It is important to remember that a sub-contractor may have limited legal advice, so any departure from familiar contract terms presents a risk of which it is rightly wary. This is not always the case, but a sub-contractor is often selected after the main contract documents are agreed, so it is difficult to predict an individual sub-contractor's position when drafting the contractual documents;
• On a large project, even if most sub-contractors agree to third party rights, one or more intransigent sub-contractors could leave the client having to amend the schedules of third party rights or accept collateral warranties in some cases;
• Procuring collateral warranties from sub-contractors is usually more convenient than trying to include a third party rights provision in every sub-contract;
• Some lenders still prefer collateral warranties to third party rights; and

The Third Party Rights Act 1999 does not allow a third party to be put under an obligation to do something (a burden). The Third Party Rights Act 1999 allows a third party to enforce the benefit of a contract term (or contract terms) only.

This article was written by Partner Fiona Edmond at Charles Russell Speechlys. For more information, please contact Fiona at fiona.edmond@crsblaw.com or on +44 (0)20 7427 4463.