Why do collateral warranties need to be provided?

What should you look out for when providing a warranty?

The use of collateral warranties has become so widespread that it is now quite rare to see a construction project which does not require the design team to provide them. Despite this, the purpose of entering into a collateral warranty is frequently misunderstood by contractors, sub-contractors and consultants.

Why are collateral warranties used?

Under English law, anyone with an interest in a building which turns out to be defective will find it very difficult, if not impossible, to pursue the designer and/or contractor who is responsible for the defect if they do not have a contractual relationship with them. This is because, in the absence of a contract, the only way of pursuing the designer and/or contractor is to bring a claim in negligence. However, it is extremely rare to recover the sort of financial losses that are caused by a defective building by bringing a claim in negligence.

The purpose of a collateral warranty is to create a direct contractual relationship between a designer or contractor and a third party with an interest in the building, such as a funder, purchaser or leaseholder. This enables the interested third party to pursue the designer and/or contractor by way of a breach of contract claim in the event that the building is defective.

Such is the importance of collateral warranties that building contracts and consultant appointments often contain a clause which makes the provision of collateral warranties a condition precedent to payment or to practical completion being certified.

What do the Courts think about collateral warranties?

Despite their popularity, there have been remarkably few legal disputes involving collateral warranties to date. The most recent case in which the use of collateral warranties was considered was the Scottish case of Scottish Widows Services v Building Design Partnership.

The case concerned the construction of a new office building for Scottish Widows Fund & Life Assurance Society (the “Society”). Building Design Partnership (“BDP”) were appointed as architects by the developer, Edinburgh Construction Services, and provided a collateral warranty to the Society, who had taken a sub-lease of the building. The Society subsequently assigned its sub-lease to Scottish Widows Services (“SWS”), along with its rights under the collateral warranty.

The roof of the building was defective and not watertight, so SWS took the decision to pay for remedial works, even though the terms of the sub-lease did not impose a repairing obligation on them. SWS then sought to recover the cost of the remedial works from BDP by bringing a claim against BDP pursuant to the warranty.

BDP argued in their defence that as the breach of contract (i.e. the defective work) had occurred prior to practical completion of the building, the only person who could have suffered a loss as a result was the person who owned the building at that time (i.e. the developer). They also argued that SWS were not entitled to recover their losses because they had not been under any contractual obligation to remedy the defects and had done so voluntarily.

The Scottish Court held that it was immaterial that SWS did not have a contractual obligation to repair the defects – they were entitled to repair the defects so that they could enjoy a watertight building. Furthermore, the fact that the defects had arisen before SWS became a tenant was immaterial, as the liability which BDP might have owed to the building owner in respect of the defects had been transferred to SWS via the warranty. The warranty had given SWS the right to sue for losses they had suffered as a result of defects in the building.

This case, although not binding in English law, clearly demonstrates that it will be very difficult for a contractor or consultant to argue that a party who has the benefit of a warranty is not entitled to bring a claim for losses caused by defects.

What should you look out for when providing a collateral warranty?

Contractors and consultants often provide collateral warranties without taking the time to carefully consider how those warranties might potentially extend their liability for defective works.

When reviewing a warranty, there are a number of key points to look out for:

How onerous is the warranty?

A warranty should never be more onerous than the underlying contract to which it relates. For example:

• if a design and build contract states that the contractor’s design must be carried out with “reasonable skill and care” and a collateral warranty states that the contractor’s design must be “fit for the purposes expressed in any specification or performance requirement”; or
• if a design and build contract requires the contractor to provide professional indemnity insurance with a limit of indemnity of £5m and a warranty requires professional indemnity insurance with a limit of £10m,

then the contractor’s obligations under the warranty are more onerous than his obligations under the design and build contract. The purpose of a warranty is to provide comfort for a third party that the contractor will comply with his obligations under the design and build contract, not to impose additional obligations on the contractor. The wording of the warranty should be amended so that it corresponds with the wording of the design and build contract.

Can you limit your liability?

Always consider whether it is possible to limit your liability under a warranty. There are numerous ways to do this, such as:

• agreeing a financial limit on liability for breaches of the warranty; and/or
• including a “no greater liability” clause which ensures that your liability under the warranty will not exceed the level of liability you would owe if the same claim were being brought by your employer under the building contract/professional appointment (however, this type of clause will only really be effective if your liability under the building contract/professional appointment is limited in some way); and/or
• including a net contribution clause, which is intended to ensure that your liability for breaching your obligations under the warranty is limited to the amount it would be fair and reasonable for you to pay based on the extent to which you are responsible for the loss suffered.

Is it clear when your liability will expire?

It is useful to include an expiry date in the warranty, so that you can be confident that no claims for breach of the warranty will be brought after a specified period of time (usually 12 years after the date of practical completion of the works).

How many third parties might be able to bring a claim?

It is sensible to seek to impose a contractual limit on the number of warranties which you can be required to provide and on the number of times each warranty can be assigned to a third party. This prevents you from being exposed to potential claims from an unknown number of third parties.

Want to find out more?

If you would like any further information about reviewing or drafting collateral warranties, please do not hesitate to contact us.