Parties involved in UK construction projects will be familiar with collateral warranties (often referred to simply as ‘warranties’) and third party rights (having either requested, or been asked to provide, these).
In this Insight, Weightmans considers how collateral warranties and third party rights operate and some of their key characteristics. In summary:
- Warranties and third party rights are well-established forms of project security provided for the benefit of stakeholders involved in construction projects.
- It is beneficial to establish early in the project, ideally before the main development and construction contracts are entered into, the scope of warranties or third party rights required (both who is to provide them and to whom) and the form(s) of warranty or terms of the third party rights.
- Warranties and third party rights should be reflective of, and go no further than, the underlying agreement to which they relate (e.g. build contract, sub-contract, appointment) so the protection offered by the warranty is like-for-like and subject to the terms of the underlying agreement.
- The primary purpose of warranties or third party rights is to warrant the obligations and liabilities within an underlying agreement to a third party that is not privy to that agreement (the ‘beneficiary’): no substantive new or extended obligations or rights should be created in the warranty that are not already in the underlying agreement. Often, ‘no greater or longer liability’ and/or ‘equivalent rights of defence’ clauses are included to reinforce that position.
- The warranty terms or third party rights require careful review because they could significantly impact the risk profile of the warranty provider, including expanding the standard of care beyond that agreed under the underlying contract/appointment, or that which can be insured, and/or extending limitation periods, and/or extending liability beyond existing caps or restrictions.
- Equally, the beneficiary will want to check the warranties to ensure that they provide adequate protection in the event of defects (particularly where they will be taking on a repairing obligation, e.g. under a lease) and that, where the beneficiary is a funder or has a major interest in completion of the project, they provide ‘step-in’ rights to enable the beneficiary to complete the project in the case of employer or contractor insolvency.
- 'Step-in' rights (allowing the warranty beneficiary to ‘step into’ the underlying contract in specific circumstances) can prove useful in a number of scenarios, in particular, insolvency in the project supply chain (an issue that Weightmans has considered previously in the following insight.
The purpose of collateral warranties and third party rights
Collateral warranties and third party rights are forms of project security, providing project stakeholders with an element of protection of investment.
Collateral warranties and third party rights create a contractual link (and a route for remedy) for parties with interests in a construction project who would not otherwise have a contractual connection to the designer or contractor who designed, or undertook, the works. For example, they can establish contractual links/remedies between funders/end users and a main contractor/consultant, or between the client and a main contractor’s sub-contractors/sub-consultants.
The party receiving the warranty (the ‘beneficiary’) gains the right to bring a contractual claim directly against the warranty provider (the ‘warrantor’). In the absence of a warranty, the beneficiary would have no contractual right to bring a claim and would have to rely on tort law which is often more difficult to establish (because the claimant must establish that the defendant owed them a duty of care outside of any contract) and has a narrower scope of recoverable loss (which often excludes losses associated with rectifying defects).
On some projects, warranties/third party rights might be required for all stakeholders that are not privy to the main contract or appointments, such as the funders, property owners, tenants and management companies. On other projects, they might be limited to key anchor tenants. Where warranties/third party rights are required, the parties receiving ‘step-in’ rights are generally limited.
Similarly, the scope of warranty providers can vary from including all those responsible for design work and/or more substantial elements of construction work to being limited to only key designers and works packages.
Obligations to provide warranties and the form of warranty
The requirement to provide (or procure provision of) collateral warranties and the form of that warranty is generally established at the point of agreeing the related contracts (e.g. build contract, funding agreement, agreement for lease, appointment, sub-contract, etc.), with an obligation to provide the warranty incorporated into the underlying agreement and the agreed form of warranty attached to it.
The warranty clause can include (i) an obligation to give warranties or (ii) can be a combined obligation to provide warranties and procure warranties from the warrantor’s supply chain (such as contractors being obliged to obtain warranties from sub-contractors).
Sometimes, the obligation to provide (and procure) warranties is linked with a financial penalty if warranties are not provided. In the absence of a financial penalty, there might be no substantial remedy for a party failing to provide a warranty (other than potentially pursuing a legal claim for specific performance, which can be costly and difficult to secure).
The form of warranty required is appended to the underlying agreement, with the scope of warranty providers and beneficiaries being specified by name or roles (e.g. lift contractor, tenant, etc) or trades (e.g. lift, structural steel, etc). Whilst some standard forms of warranty are available, e.g. JCT, CIC and ACE, most beneficiaries (and particularly funders) require bespoke forms of warranty that better suit their requirements.
In summary, the warranty terms provide that the warrantor warrants compliance with the underlying agreement, i.e. guarantees its performance thereunder and grants similar rights under warranty as those under the main agreement, to the beneficiary. The value of the warranty is therefore subject to the strength of the underlying agreement. If the underlying contract contains exclusions or limits of liability e.g. exclusions of certain classes of liability, or a financial cap on total liability, or a net contribution clause (examples of which can be found in the JCT standard form of warranty), then the warranty will be subject to the same limits and the beneficiary's scope of recovery similarly limited.
The distinction between warranties and third party rights
Collateral warranties and third party rights are alternative routes to achieve the same purpose, and therefore the relevant rights and obligations are comparable.
The main distinction between warranties and third party rights is that a collateral warranty is a separate contractual document which sets out the terms of warranty, and which must be executed by all parties to it.
In contrast, third party rights are a set of rights specified in the underlying agreement, which the ‘employer’ under that agreement can grant to a beneficiary by serving notice to the contractor or consultant specifying the third party to whom those rights will be given.
This ability to grant rights is permitted outside the normal contractual framework through the Contracts (Rights of Third Parties) Act 1999, which allows a contract to explicitly permit a third party to enforce the terms of a contract it is not directly party to, provided that the rights granted and the identity (or class) of potential beneficiaries is clear in the contract. Those wishing to streamline contractual paperwork may prefer third party rights, however, in practice many parties still require collateral warranties.
Collateral warranties often tend to be preferred, potentially because of tradition and familiarity, but an additional factor is that is easier to provide ‘step in’ rights under a warranty than using third party rights. This is because ‘step-in’ rights usually include notice obligations on the beneficiary to exercise those rights and the 1999 Act does not permit the bestowing of obligations, only the granting of rights. Whilst this can be addressed with careful drafting of third party rights (by making the ‘step-in’ rights conditional upon specified notices), collateral warranties are often used when ‘step-in’ rights are required.
Key features of a warranty/third party rights
Some key features of a warranty / third party-rights to note are:
- Consideration
- No greater liability and equivalent rights of defence
- Standard of care
- Prohibition of deleterious materials
- Professional indemnity insurance
- Step-In (where required)
- Copyright
- Assignment and no loss arguments
- Limitation period
Consideration
Consideration is the mutual exchange of promises or obligations between parties of a contract and is a necessary element to create a valid contract, unless the contract is formally executed as a deed, as deeds do not require consideration.
Whilst most warranties are entered into as deeds (to provide for a longer limitation period – see below), they typically still state that consideration of a nominal amount (for example, £1 or £10) is paid and acknowledged, as an extra layer of protection in case the deed is improperly executed.
No greater liability and equivalent right of defence clauses
The primary purpose of a warranty/third party rights is to create an ability for a third party to enforce the terms of an underlying agreement against the warrantor (despite not being party to the underlying agreement). Therefore, important terms for the warranty provider are (i) a no greater liability clause and (ii) an equivalent rights of defence clause. Whilst these clauses are similar, they have slightly different effects.
A no greater liability clause provides that the warranty providers’ liability under the warranty is no greater than the liability it has to the employer under the main contract/appointment/sub-contract to which the warranty relates.
An equivalent rights of defence clause enables the warranty provider to rely on any defence available to it under the main contract/appointment/sub-contract when defending any claims brought under the collateral warranty, such as a limitation or cap on liability.
From a beneficiary’s perspective, it will want to ensure that any such provisions exclude the effect of any set-off, counterclaim, waiver or compromise appliable to the main contract/appointment/sub-contract. This is because it should not be prejudiced by issues or disputes between the warranty provider and its direct employer.
Standard of care
Warranties/third party rights usually state that the warrantor warrants/undertakes to comply with the terms of the underlying agreement.
This is often supplemented with a separate obligation that the warrantor will exercise reasonable skill and care in its design and the selection and use of materials and goods.
The standard of care should reflect what is in the underlying contract/appointment. The drafting of any reasonable skill and care clause requires careful consideration. Small differences in language can impose quite different levels of obligation. For example, the use of the word “all” before reasonable skill and care can impose a stricter obligation than simply referring to “reasonable skill and care”. The same can be said of using the word "diligence". The standard of care may refer to the standard to be expected of a “competent” “designer” or “architect”. The use of the word “competent” could be problematic as the standard of care itself is intended to establish what should be considered competent. Depending on the extent of design responsibility, it may be appropriate to instead refer to the standard of care to be expected in the warrantor’s profession.
Professional indemnity insurers will generally not cover fitness for purpose obligations in respect of design. Therefore, any wording referring to compliance with performance standards and/or fitness for purpose should be very carefully considered. Crucially, the presence of a fitness for purpose obligation might not just result in that obligation being uninsurable, it could render all obligations under the agreement uninsurable, undermining the insurance in place altogether.
Prohibition on deleterious materials
In addition to the general overarching standard of care, warranties often include a separate obligation to not specify, use, or permit use of any ‘deleterious’ materials (what is deleterious is usually defined by reference to established industry standards).
Whether the prohibition is a strict obligation or subject to the standard of reasonable skill and care is often a subject of negotiation between the parties.
Professional indemnity insurance
Warranties usually set out an obligation for the warrantor to hold and maintain appropriate professional indemnity insurance; that obligation should reflect any similar obligations in the underlying contract and the level and type of insurance held (including the basis of cover, whether any one claim or in the aggregate, and any limits or exclusions). Usually, the obligation to maintain professional indemnity insurance runs until 12 years after completion of the project or the relevant works or services.
Step-in
Step-in rights permit the beneficiary to step into the underlying contract and proceed as ‘employer’ under it. Step-in rights offer a solution to allow the project to continue in a situation where a party has either been terminated or is insolvent. This is a very useful tool in those circumstances. There may be a specified procedure to be followed before step-in rights can be exercised e.g. prior written notices, from the warrantor and the beneficiary, and exchange of information to help determine whether step-in is appropriate.
Copyright
It is usual for the warrantor to provide a licence to the beneficiary to use copyrighted material. Some warranties may seek to include additional provisions requiring indemnities in respect of any breach of copyright. Any such terms (particularly requests for indemnities, which may not be covered by insurance) will require careful consideration.
Assignment and no loss arguments
Warranties have a value and so are assignable i.e. the benefit of the warranty can be transferred to another party. This could become relevant if the beneficiary sells their interest in the relevant property.
The scope of assignability for warranties may vary and the number of assignments is often limited and subject to consent. The usual position is that a beneficiary has the right to assign the benefit of a warranty on at least two occasions without the permission of the warrantor. Assignments by way of security and inter-group assignments may also be permitted.
Practical commercial issues need to be considered, such as whether notice of assignment must be given and whether the benefit of a warranty (and therefore the obligation to make payment in the event of step in for example) might be impacted be assignment to a party of different commercial strength.
Assignment can raise the possibility of a “no loss argument”. This can arise where the original beneficiary has assigned its warranty to a new party, the warrantor is in breach of its obligations, but its breach has not caused or would not have caused the original beneficiary to suffer any loss. In such circumstances, the warrantor could argue that the fact the original beneficiary would suffer no loss means that the rights assigned to the new party will apply subject to that, i.e. the assignee’s rights is only to recover the loss that the original beneficiary would have, which is none. Often, exclusions of no loss arguments against assignees are included to avoid this type of argument.
Limitation period
The limitation period should mirror what is set out in the underlying contract.
Often each warranty on a project will be drafted so that all warrantors have liability until the same point, e.g. 12 years after practical completion of all works (rather than 12 years from the date of breach or completion of the relevant services or sub-contract works). This may require most careful consideration if the warrantor is providing services or works which will be complete either much earlier in the programme (or sometime after completion).
It is important to note as well that express limitation terms cannot cut across certain statutory limitation periods, most notably the extended limitation periods provided for under the Building Safety Act 2022 and the Defective Premises Act 1972 (as amended).
Negotiation of warranties/third party rights
The terms of any form of warranty or third party rights should be confirmed with all intended parties at the earliest opportunity. Often, the required form of warranty is appended to the build contract, appointment, or sub-contract to which it relates. When that is the case, there may be difficulties if any future beneficiary (such as a funder or tenant engaged part way through the project) has not agreed that form and then seeks amendment further down the line. Similarly, sub-contractors often request amendments to the form of sub-contractor collateral warranty agreed by their main contractor before the sub-contract was engaged.
The nature and value of work being carried out are key factors in what should reasonably be required or expected.
Consideration must be given to any restrictions on insurance cover in respect of obligations arising in connection with warranties or third party rights. Insurance cover can often exclude certain types of works or liabilities under warranties which go beyond the underlying contract liability or include any fitness for purpose obligations. If a liability may not be covered by insurance, it will be a commercial decision for the warranty provider whether to agree the warranty and accept the uninsured risk, though failure to provide or obtain a warranty which is a contractual requirement can have financial consequences.
Additionally, beneficiaries should be aware that some insurance requirements (such liability caps, net contribution clauses, and exclusions of certain categories of loss) are conditions of cover, meaning if they are not provided for in the warranty, the insurer will not cover A5NY of the liability under the warranty.
Given the various complexities and nuances of drafting and dealing with collateral warranties and third party rights, Weightmans can provide tailored advice on all issues related to them.
This insight is also co-authored by Paralegal, Jennifer Roberts jennifer.roberts@weightmans.com and Solicitor, Irmina McKenzie irmina.mckenzie@weightmans.com.
