Understanding collateral contracts

Clients, tenants and funding banks are today very concerned at the financial viability of their contractors. In consequence there is an increasing demand for agreements between key sub-contractors and the user or beneficiary of a project.

These agreements come in one of a variety of forms including third party rights provisions, collateral contracts and the like. All these arrangements seek to create a legal link between the provider of goods and services and the user of the facility.  

In many cases, concern at the financial stability of the contractor or subcontractor is under-written by a third party such as a bondsman or insurance company in the form of performance bonds, parent company guarantees and worst of all, on demand bonds.

These third parties are not altruistic in the provision of a guarantee; first they require a fee and then they want protection for the risk of insolvency by asking the contractor or subcontractor’s bank to underwrite the guarantee by ring fencing part of the firm’s assets or borrowing facility. The immediate effect is to reduce the firm’s asset base and in consequence, reduce their ability to trade.

For the payment of £1 the beneficiary gets a guarantee on a substantial value of work. To make matters worse, these agreements are often signed as a deed giving the beneficiary the right to make a claim for any perceived problem for up to 12 years from the date of practical completion of the work

For the most part, collateral contracts form a binding contract which agrees that for the payment of £1 (which is deemed to have been paid), the contractor or subcontractor guarantees his design, his work, the material he has supplied and other specific issues.

In summary, for the payment of £1 the beneficiary gets a guarantee on a substantial value of work. To make matters worse, these agreements are often signed as a deed giving the beneficiary the right to make a claim for any perceived problem for up to 12 years from the date of practical completion of the work.

The sting in the tail in these uncertain times is that contractors and subcontractors who provide collateral contracts or similar guarantees could find they are not paid by their immediate client because of insolvency.

Notwithstanding the insolvency of the paymaster unless appropriate provisions are made when a defect is found the beneficiary of the collateral contract can still make a claim using the guarantee (as it is a binding contract). Such a claim would still be valid even if payment has not been paid to the unfortunate contactor or subcontractor for the work installed.

Protection can be provided from such risk by requiring the following wording to be inserted into the document. The contractor (or subcontractor) their assignees, successor(s), guarantor(s), or bondsman shall not be liable to the beneficiary (or their assignees or successors) unless contractor (or subcontractor) has been paid the total value of their agreed final account.

Paul Lomas-Clarke is executive director at Knowles Bedford Row, London Offices