Collateral warranties

The purpose of a collateral warranty is to create a contractual relationship between parties that would not otherwise exist; for example, between an end user of a building and a consultant.

If no contract exists, then the parties would have to rely on their common law rights which are generally regarded as unsatisfactory, in terms of the types of losses that can be recovered, by those who have to enforce them. In essence, the right of recovery is extremely limited. A collateral warranty – which is 'collateral' or alongside the principal contract (such as an appointment) – seeks to bridge this gap and to place a liability in contract upon the giver to the beneficiary of its terms.

Warranties are commonplace and have steadily evolved to include wide-ranging provisions, from insurance and copyright clauses to step-in rights (explained below). They are generally sought from those with a design responsibility by a beneficiary involved in the project who would usually be a bank, a purchaser or tenant of the development, or sometimes the developer itself. For example, this might occur in a design and build contract where the developer has no contract with the professional team engaged by the design and build contractor.

Most warranties require the party giving the warranty to have and to maintain a specific level of professional indemnity insurance as a significant claim would undoubtedly put many small contractors and consultants out of business. It is vital, therefore, when giving warranties, that the provisions of the warranty are covered by the policy.

Step-in rights
Step-in provisions are most commonly found in warranties given in favour of funders and freehold purchasers. They enable the beneficiary to take over the contract with the contractor or consultant where the contractor or consultant has a right to terminate that contract or if the funding agreement has been breached. For example, where the beneficiary is a bank, it may exercise a right of step-in if the borrower has breached the terms of the loan agreement.

Step-in provisions usually contain some provisions allowing for a period of notice. For example, there may be a right for the beneficiary to serve a notice requiring the contractor/consultant to carry on working for the beneficiary in place of the employer or client.

An important consideration is the length of notice the contractor/consultant is required to give. Even if the beneficiary decides not to step-in, the contractor/consultant has to continue working during the notice period incurring costs which may not be recovered.

In addition, any giver of a warranty should check what is the position in relation to payment of costs or fees outstanding at the date the beneficiary wishes to exercise a right of step-in.

Copyright licence
Most warranties contain an irrevocable, royalty-free copyright licence in favour of the beneficiary to enable it to use the information at no additional cost. A consultant would be well advised to read this provision carefully. Should the licence only be given if all fees have been paid? The consultant should not be responsible for use by the beneficiary of drawings which was not contemplated by the professional when they were prepared.

Net contribution clauses
Where losses are incurred, net contribution clauses serve to put the risk of insolvency on the person or persons suffering the loss. The clause usually provides that each party responsible for the loss should be treated as having contributed to a fair proportion of it for the purpose of calculating the liability of the giver of the warranty.

For example, if there are five parties equally responsible for a loss, an effective net contribution clause should mean that the giver of the warranty is liable for one fifth of the losses (and not all of them).

Net contribution clauses are unpopular with developers and investors as they affect the recovery of losses. On the other hand, insurers are usually in favour of them because they reduce their exposure.

Limitation/exclusion clauses
The warranty should not impose a greater liability in time upon the giver than is already imposed under the original contract. If a contract is executed as a 'simple' contract (ie signed under hand) the limitation period, or the period during which claims must be brought, is six years from the date of breach.

This period is extended to 12 y if the contract is executed as a deed. Therefore, if an appointment is signed as a 'simple contract', the warranty and any period by which claims should be brought must also be limited to six years (usually from practical completion).

Another form of limitation is one where the giver of a warranty seeks to limit the extent of its liability to a beneficiary. For example, a consultant may wish to restrict its liability in the event of a breach of contract to the cost of remedying the physical defect which results from the breach.

All other consequential losses (for example the loss of rent) would be excluded. This often causes great difficulties in the negotiation of collateral warranties.

Summary
The scope for difficulty in negotiating collateral warranties is huge, as there are many variations on clauses. Advice should be sought from insurers, brokers and/or lawyers.

The trend in the future will probably be for third party rights (rights in favour of third parties, such as funders, purchasers and tenants) to be included within a building contract or appointment in order to circumvent the requirement for collateral warranties.

However, beware. Such third-party rights are designed to have the same effect as collateral warranties and will include the sort of provisions referred to above. For that reason third-party rights will need just as much careful consideration as the terms of the collateral warranties themselves.