Thursday 27 February 2014

COLLATERAL WARRANTIES


COLLATERAL WARRANTIES

The collateral warranty or collateral agreement, as we know it in the construction industry,  became a ubiquitous feature of project documentation in the wake of the English House of Lords decision in D&F Estates-v-Church Commissioners for England (1989 1AC 177). In that case, a tenant of “Chelwood House” sued the builder in the tort of negligence (it had no contractual relationship with the builder- the builder having contracted with the developer) for losses it incurred in rectifying defective plasterwork in its building. The tenant’s claim was unsuccessful as the House of Lords classified the loss incurred in rectifying the plasterwork as “pure economic loss” which it held was a type of loss not recoverable in tort. Lord Bridge of Harwich stated:

 

“ it seems to me clear that the cost of replacing the defective plaster itself... was not an item of damage for which the builder of Chelwood House could possibly be made liable in negligence.... to make him so liable would be to impose on him for the benefit of those with whom he had no contractual relationship the obligation of one who warranted the quality of the plaster as regards materials, workmanship and fitness for purpose. I am glad to reach the conclusion that this is not the law...”

 

Once it was determined that, as a matter of law, this type of loss could only be recovered in an action for breach of contract- the collateral warranty was born. Before a construction project gets under way a number of principal contracts will be entered into between the principal parties responsible for delivering the project: employer/design team; employer/contractor; contractor/subcontractors etc. The collateral warranty is a separate contract which exists side-by-side (and refers to) the relevant principal contract. The beneficiary of a collateral warranty will be a party who has or may assume an interest in the completed building but who is not a party to a principal contract with one of the key players in the construction process that it may wish to sue should it suffer a loss due to that key player’s default.   Collateral warranties will typically be entered into between: funding institution/ contractor; funding institution/design team; design team/ purchaser or tenant; contractor/purchaser or tenant; employer/nominated subcontractor etc

 

 

 

A collateral warranty can take the form of an industry standard or more commonly in recent times a bespoke warranty.  The construction industry has produced standard collateral warranties such as the contractor collateral agreement  (“orange form”) and the nominated subcontractor collateral agreement (“green form”) both published by the Royal Institute of the Architects of Ireland in agreement with the Construction Industry Federation and the Society of Chartered Surveyors; the Royal Institute of the Architects in Ireland has its own standard collateral warranty for use by its members.  Particular care and attention should be taken in reviewing and negotiating bespoke collateral warranties, that is, warranties that have been specifically drafted by lawyers acting for the beneficiary (the employer, funding institution, purchasers, tenants) as these can be heavily weighted in their clients' favour.

 

Some of the topical issues that can arise in relation to collateral warranties are as follows:

 

Is There An Obligation To Execute A Collateral Warranty?

It is not uncommon that the request for a collateral warranty arises after the principal parties have already entered into contract.  A party does not have to provide a collateral warranty if it is not contractually obliged to do so.

 

Main Warranties

The main warranties usually provide that the warrantor “has not broken and shall not break any express or implied terms of the contract”. The “contract” being referred to is the relevant principal contract.  Accordingly, in the example given above, if the tenant of Chelwood House had entered into such a collateral warranty with the contractor, the defective plaster would give rise to a breach of the collateral warranty. In such circumstances, the tenant could have successfully sued the contractor for breach of warranty for losses it incurred in rectifying the plasterwork.

 

Standard of Care

 

The standard of care required by warrantors (and more importantly their professional indemnity insurers ) is one of “reasonable skill and care.” Beware of warranties that prescribe a standard of care requiring “fitness for purpose” which can arise, for example, where there is a design obligation under the contract. The problem with fitness for purpose is that the beneficiary does not have to prove negligence-if it doesn’t work, it’s not fit for its purpose. Accordingly, professional indemnity policies may exclude indemnity for fitness for purpose.

 

Limitation of Liability and Net Contribution Clauses

When negotiating a bespoke collateral warranty, the prospective warrantor will attempt to negotiate terms to limit its liability to the beneficiary under the warranty, a good example of which is clause 3 of the standard contractor collateral agreement “orange form”, where the contractor is only liable for “the reasonable costs of repairing any defect, omission or other fault in the construction of the Works” with liability for consequential losses and/or a loss of profit expressly excluded.  A net contribution clause will also seek to  limit the liability of the warrantor to that proportion of the loss for which it is just and equitable for the warrantor to have to pay having regard to the extent of the warrantor's responsibility for the beneficiary’s loss.

 

Assignment

Assignment refers to the right of a beneficiary to pass on the benefit of the collateral warranty to a third party. It is understandable that when a purchaser or tenant wishes to dispose of its interest in a property it would wish to make a prospective sale or assignment of lease more attractive by passing on any warranties it enjoys to a subsequent purchaser or tenant. From the warrantor’s point of view an assignment of a collateral warranty may mean being sued years later by a stranger whom it has never heard of. Difficulties negotiating the assignment clause can arise in relation to the number of permitted assignments and whether the wording of the assignment has appropriate words of limitation to prevent a continuing obligation on the warrantor to enter into successive collateral warranties.  

 

Step In Rights of the Beneficiary

Step in rights by way of novation will typically be required by a funding institution to allow it discretion whether to step into the contractual shoes of the employer to ensure that the project is brought to practical completion in circumstances where the warrantor has a contractual right to terminate the principal contract. This will usually arise where the employer defaults in making payments to the warrantor under the principal contract. When negotiating such a clause, the prospective warrantor will be seeking to include an undertaking that the beneficiary will, on stepping in, pay the warrantor all outstanding monies due to it under the principal contract.

 

Duration of agreement

It is good practice to expressly define in the collateral warranty the period for which the warrantor remains liable to the beneficiary under the warranty. The Statute of Limitations Act 1957 prescribes a twelve year liability period for contracts executed under seal and a six-year liability period for contracts executed under hand. It is equitable that the period of liability under the collateral warranty should be consistent with and no greater than that under the principal contract.

 

Wealth Warning

Collateral warranties should be carefully reviewed and negotiated. Particular regard should be had to exclusions under the relevant insurance policies. Before agreeing to enter into a collateral warranty, it is prudent to seek the advice of your insurer and legal adviser.