This month’s contract clinic question comes from a main contractor trying to decide whether to avoid using collateral warranties on its next project, by using the Rights of Third Parties Act instead. Ruth Wilkinson and Isabel Saunders provide the response.
The question
Somebody has told me we can avoid collateral warranties on our next project, by using the Rights of Third Parties Act. Is that a good idea or should we avoid it?
The answer
It depends on what is meant by ‘avoid’. Collateral warranties and third-party rights have many similarities and should be seen as alternative options, intended to achieve the same result.
What is a collateral warranty?
A collateral warranty is a contract that sits alongside an underlying contract, usually a building contract, consultant appointment or subcontract.
Normally the client or main contractor would issue collateral warranties to subcontractors. Using the Contract (Rights of Third Parties) Act 1999 is a different way of doing things at procurement stage, when the contacts are being negotiated.
Most collateral warranties refer to the duties and obligations in the underlying contract. They warrant that the contractor, consultant or subcontractor (for these purposes the ‘warrantor’) has performed or will perform those obligations for the benefit of a third party.
The warranty creates a contractual link between the warrantor and a third party, normally a purchaser, tenant or funder. It entitles the identified third party to rely upon the promises in the warranty and bring a claim for breach of contract.
Contract (Rights of Third Parties) Act 1999
The Contract (Rights of Third Parties) Act 1999 creates an ability for a third party who is expressly identified in the contract (by name, class or description) to bring a claim against a warrantor where there has been a breach of the contract.
It does this by creating an exception to a principle called ‘privity of contract’. This principle means that only a party to a contract can have rights or obligations under it.
“The choice of whether to require collateral warranties or third-party rights is usually a matter of preference for the employer and the proposed third parties.”
It is usual to see specific rights given to a third party and these are usually set out in a schedule of third-party rights. Such a schedule is usually in almost identical terms to a collateral warranty. There may be provision for the rights to be automatically vested in a party on execution of the contract. Alternatively, they may be vested on receipt of a written notice identifying the third party.
It is common practice to see a clause in a contract which excludes the operation of the Contract (Rights of Third Parties) Act 1999. This is to avoid unknown parties from inadvertently being entitled to benefit from enforcing it. If third-party rights are to be used, then any exclusion needs to carve out the rights of any third parties who are intended to have such rights.
How do collateral warranties work in practice?
The benefit is to provide performance security to a third party in the event of a breach of contract by the warrantor (in relation to defects). These are especially useful to a client if the main design and build contractor becomes insolvent. An employer is usually required to obtain such security from its lenders or it is necessary to ensure onward sale or leasing of the property.
The choice of whether to require collateral warranties or third-party rights is usually a matter of preference for the employer and the proposed third parties. Some see third-party rights as more convenient and cost-effective as they do not require collateral warranties to be prepared, negotiated and drafted.
Collateral warranties may require chasing for months, and in some cases years, after the works have completed. In contrast, a notice can be issued without the need for any response, provided the notice does not require acknowledgement of the warrantor.
In practice, collateral warranties remain more common than third-party rights. This is especially the case with subcontractors – perhaps because of the prevalence of bespoke terms of subcontract.
As a warrantor, giving either collateral warranties or third-party rights extends your liability beyond your direct employer. For each contract you should check whether you are required to provide either.
If yes, you should: identify the scope of potential beneficiaries (limiting this if possible); review (and negotiate) the terms of the warranty or third-party rights schedule; and consider the impact on your price, professional indemnity insurance and any caps on liability.
Ruth Wilkinson is legal director and Isabel Saunders an associate at Hill Dickinson LLP.
