Collateral warranties and third party rights

Collateral warranties and third party rights will be familiar terms to most people involved in the property sector, but what is the difference between them in practice?

Collateral warranties

Who gives collateral warranties? They are typically given by main contractors, consultants and design sub-contractors. They allow a third party (i.e. someone who was not a party to the underlying building contract, appointment or sub-contract) to bring a claim against the contractor/consultant/sub-contractor if the relevant works or services were performed negligently. The beneficiary would not be able to do that without the warranty. This is known as ‘privity of contract’ – the principle that a contract cannot give rights to a person who is not a party to it.

Who would require a warranty? The beneficiary of a warranty will have an interest in the works being completed to the requisite standard. Using the example of a project for the construction of a new building, typical beneficiaries are:

• a funder lending on the project
• a purchaser who buys the building
• a tenant taking a lease of the building.

Why collateral? They are collateral as they are collateral to the underlying contract. This is illustrated by the key term of a collateral warranty – the warrantor undertakes to the beneficiary that it has carried out its works/services in accordance to the standards required by the contract; for example, that the design has been carried out with reasonable care and skill and that the physical works have been carried out in a proper and workmanlike manner. They are also collateral in the sense that the duties owed under a collateral warranty should go no further than the duties owed under the underlying contract.

Why are collateral warranties needed? Often a funder/purchaser/tenant won’t need to bring a direct claim against the supply chain as they will have recourse under their own contracts. For example, under the terms of a typical development agreement, a developer/landlord will have obligations to the tenant in regard to the standard of any landlord’s works. But what if the developer goes insolvent before the works are completed and the works are defective? In that situation, the tenant is left with no recourse for remedying the defects as they have no contract with the supply chain. So insolvency is where collateral warranties are most relevant. They plug that contractual gap and provide the beneficiary with a direct right of action which it wouldn’t otherwise have.

Third party rights

Third party rights have the same effect as collateral warranties (creating that direct right of action) but go about it in a slightly different way.

The Contract (Rights of Third Parties) Act 1999 (the Act) creates an exception to the privity of contract rule. The Act allows a third party to enforce the terms of a contract, even though it is not a party to it. In order to do this, the third party must be sufficiently identified in the contract and the rights being conferred must be sufficiently identified in the contract.

To look at how a JCT building contract does this:

• The contract particulars contain an option for the beneficiary/beneficiaries to be named. This can be done either by naming them specifically or by class, e.g “all tenants of the completed building”.
• The rights being conferred are set out as a schedule to the contract. This schedule repeats the terms of the building contract which the beneficiary would need to enforce such as those dealing with the standard of the works.
• To grant the rights, the employer sends a notice to the contractor identifying the relevant beneficiary and confirming that the rights have been conferred. The notice is effective as soon as the contractor receives the notice.

What is the difference in practice?

Whilst they both achieve the same goal of giving direct recourse, one obvious difference between these two options is that with third party rights, nothing needs to be signed by the warrantor. Provided the contract caters for third party rights sufficiently, the sending of a notice is sufficient to grant the rights.

So this would suggest that third party rights have taken over from collateral warranties with such a saving on admin. Not the case! Whilst both are used, collateral warranties are still more common. It seems that third party rights lack one key feature – the feeling of comfort to be had from receiving a physical document which has been signed – old habits die hard!