Contractor and third party looking over plans

Collateral warranty spotlight

What is a collateral warranty?

Every construction project is accompanied by an array of documents – from plans and specifications to permissions and contracts ­– and some are also subject to a collateral warranty1. Although they have been around in the industry for a long time, collateral warranties in construction can be time-consuming and difficult to arrange2.

Naturally, any uncertainty in construction documentation, including collateral warranties, creates risk, so it is vital that anyone entering into a collateral warranty agreement understands what they are, how they work, and some of the rights and responsibilities they commonly set out.

Collateral warranty definition

A collateral warranty in construction is a contract under which a professional consultant, such as an architect, engineer, surveyor or building contractor/sub-contractor warrants to a third party, such as a funder, purchaser, or tenant, that they have complied with their professional appointment, building contract or sub-contract.

In essence, a collateral warranty is a way of giving contract rights to a party with an interest in a construction project, when they are not provided those rights under the main contract. 

Collateral warranties often include obligations that affect the consultant or contractor – for instance using materials of an appropriate quality and carrying out work in a professional manner3. What’s more, they give the third-party funder, tenant or purchaser contractual rights enabling them to claim for losses incurred through defective design or construction1.

Collateral warranty example

The role of the collateral warranty in construction is perhaps best illustrated by way of example.

An employer might engage a developer to work on the construction of a new hotel and, in turn, the developer appoints a contractor to take on the building work – with that developer/contractor relationship governed by a building contract1.

The issue for the employer in this scenario is that it has no direct contract in place with the contractor1. So, despite having a development agreement in place with the developer, it is essentially a third party to the building contract. As a result, the employer would have little to no protection in law against any potential losses if, for instance the contractor makes a mistake during design or construction, resulting in a defect in the completed work3.

In these circumstances, a collateral warranty serves to bridge the gap between the employer and the contractor1, giving the employer the right to enforce the original building contract and to claim any losses directly from the contractor that caused them.

Similarly, the eventual purchaser or tenant of the hotel, without a direct contract with the builder, would suffer the same lack of contractual protection against defective workmanship and may seek similar protection against future losses by putting in place a collateral warranty1.

Collateral warranty considerations

The main purpose of a collateral warranty, is to grant a third party a duty of care from a building contractor, professional consultant, or sub-contractor. However, a collateral warranty may specify a range of other provisions, including but not limited to4:

  • The obligation to use reasonable skill and care in the performance of services being performed in the underlying contract.
  • ‘Equivalent rights of defence’ wording (which gives the granter the protection of any limitations built into their appointment carrying through to the collateral warranty).
  • A grant of an unconditional copyright licence.
  • Clear limitation period.
  • Step-in clauses.
  • Obligation to maintain professional indemnity (PI) insurance.

Contractors, sub-contractors, consultants or sub-consultants, whatever the discipline, are legally obliged to grant a collateral warranty if there is an obligation to do so under their main contract/appointment.

Collateral warranty insurance

Finally, for organisations providing collateral warranties, there are a number of insurance considerations to take into account.  A collateral warranty may increase a contractor’s overall exposure to liability by expanding the number of organisations that could make a claim against it, and extending the time period after construction that a claim could be brought.

On the one hand, this makes it all the more important to carefully consider collateral warranty wording – for instance including ‘no greater liability’ clauses and clauses to limit the period covered by the warranty5.

Equally, it is very important to review professional indemnity (PI) insurance arrangements. PI policies pick up design failures and not constructions issues i.e. workmanship. Therefore, it’s important to seek the support of an expert broker – before finalising a collateral warranty, to ensure the policy already in place offers sufficient protection.

At Marsh Commercial, our professional indemnity for construction professionals includes a collateral warranty review service (dependent on insurer terms and conditions) – to help ensure our construction clients can enter collateral warranties with confidence – secure in the knowledge that they have appropriate insurance in place.

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