What are the practical implications of collateral warranty obligations in third party agreements for employers and developers?

Issues to consider before agreeing to obligations that are not fully within your control

Collateral warranties are notorious in the construction industry for being forgotten and/or difficult to conclude, but their significance should not be underestimated as neglecting to complete them can leave the beneficiary without recourse should a defect arise. This article sets out key practical points to consider when negotiating collateral warranties and corresponding obligations in third-party agreements.

This article by construction law expert Simone Protheroe explores issues that can arise when third-party agreements contain pre-set obligations in relation to the procurement of collateral warranties.

Considerations in a common design and build procurement model

Let’s assume we have a common design and build procurement model with an employer, a main contractor, a design consultant and a sub-contractor. Let’s further assume that the works include highways works and so the employer has entered into a separate s278 Agreement with the local authority, and that the works are being funded by an independent funder in accordance with a separate facility agreement.

In these circumstances it is not unusual for both the local authority and funder to request an entitlement to collateral warranties from the supply chain and for the corresponding s278 Agreement and facilities agreement to contain obligations on the employer to procure the same. Against this backdrop, therefore, the key issues for the employer to consider when agreeing to provisions are:

Should CWs be a pre or post-condition?

The third-party beneficiary will want the benefit of collateral warranties. as soon as possible, thereby protecting their relevant interest by creating a direct right of recourse against the warrantor. Therefore, the third-party will seek for the collateral warranties obligation to be a pre-condition to completion of the relevant third-party agreements and/or as a pre-condition to completion of the works.

The difficulty with this is that:

(i) resistance from the supply chain to the terms of such collateral warranties or

(ii) administrative delay to their completion can result in a knock-on delay to the employer receiving relevant funds from the funder or a delay to the programme which results in an increase to the contract price and could cause the employer to breach target date obligations in the third-party agreements.

Therefore, it is recommended to proceed with caution when agreeing to collateral warranties being a pre-condition. In agreeing to such a pre-condition, the employer should be confident that the contract and consultant are aware of their corresponding warranty obligations in advance (i.e., at tender stage) and have already priced and programmed with the understanding such warranties are required and that no last-minute negotiations are anticipated.

If the supply chain is already in contract when the third-party agreement is being negotiated and is not yet aware of such obligations, we would recommend seeking to agree collateral warranties as a condition subsequent to completion of any third-party agreements.

Template forms

To mitigate the risk of collateral warranties negotiations causing delay, it is common to append template forms of warranty to the relevant third-party agreements. Whilst this can be beneficial to both the employer and the relevant third parties, difficulties arise when the template form has not been forwarded to the supply chain.

It is important to remember that, in the eyes of the contractor and consultant, a collateral warranties increases the risk profile as it exposes the warrantor to additional claims from a third-party. Therefore, the supply chain is going to be resistant to template forms of warranty which go beyond the risks in their underlying contracts. The earlier the supply chain receives and reviews the template warranties, the less chance of last-minute negotiations placing the employer in breach of the relevant third-party agreement.

Whilst pre-agreed forms can be preferable, the employer should consider if wording is required in the third-party agreement to allow for the template to be amended with the third-party’s consent (acting reasonably) to allow for flexibility in the market.

This is of particular relevance at present given the rapidly changing insurance market. Against this backdrop, we would recommend considering drafting the third-party agreement so that the third-party’s minimum requirements are stipulated whilst also allowing for reasonable amendments where required.

Limits on the number

Given each additional collateral warranties increases the level of risk exposure to the warrantor, warrantors are likely to become less amenable the more times warranties are requested.

To combat this, one can limit the number of warranties the third-party is entitled to request from the outset.

Similarly, whilst the third-party agreement may only expressly entitle the third-party to the benefit of two collateral warranties, the template may contain a clause entitling the beneficiary to directly request further warranties from the warrantor and/or its sub-contractors. This provision may be overlooked and not passed on to the lower tier contractors, who then resist and are not contractually obliged to provide such warranties which, in turn, places the employer in breach of its third-party agreement.

Particular care, therefore, should be given to the number of warranties the relevant third-party expects from the outset.

Assignability

Assignment is a “boiler plate” clause with the market standard position being that the relevant beneficiary is entitled to freely assign on up to two occasions with group companies and funders carved out.

However, we have seen scenarios where a funder is a complex multi-tiered corporate structure that is obtaining internal and external funding of its own. There is a risk in this scenario that the definition of “funder”, if not sufficiently broad, only applies to funders providing direct finance to the works. Therefore, the transaction needs to be considered in the round to ensure it is future proofed for anticipated corporate restructuring or sale.

Insolvency and completion

Insolvency is always a risk. We have recently acted for a tenant of a warehouse where the landlord was obliged to procure collateral warranties from its contractor, the sub-contractors and design consultants in our client’s favour. The warranties were signed by the main contractor but, before being signed by all parties and completed, the main contractor became insolvent and the administrator’s consent was required for the warranties to be completed. Further, the main contractor warranty now offered no comfort to the tenant.

The lease was silent on the issue and we assisted in agreeing a deed of variation whereby the landlord’s repair obligations were widened so the landlord is “standing behind” the contractor’s works.

To draft for this scenario in advance, one could include provision containing a pre-agreed solution. From the employer’s perspective, an option is to ensure the obligation to procure such a warranty is waived should a member of the supply chain become insolvent prior to completion, and to make it clear, once signed warranties are forwarded to the third-party for their signature, that any delay in completion to the same is a risk for the third-party beneficiary.

Lost copies

What happens if the warranties are all signed but are lost when being delivered to the beneficiary?

Advancement in technology and the use of electronic execution platforms minimises this risk. However, it is prudent to consider the risk of having to return to the supply chain and seek their agreement to re-sign a suite of warranties which may result in resistance. Therefore, it is recommended that wording, as at point 5 above, that the beneficiary takes risk of completion and that once the warranties have been signed and forwarded to the beneficiary the employer has satisfied its obligation of delivering warranties in the beneficiary’s favour is included.

The above is not an exhaustive list of all practical implications connected to the procurement and delivery of third-party collateral warranties. However, it highlights the wider factors that should be considered when signing a simply worded clause and relatively market standard obligation.

For further information on collateral warranties or construction law, please speak to a member of our team by requesting a consultation.