Building Blocks: What is a Collateral Warranty?

What is a collateral warranty?

A collateral warranty is a contract under which a party involved in the works warrants to an interested third party (i.e. usually defined as a beneficiary) that it has fulfilled its obligations under the main contract (underlying building contract, subcontract or professional appointment).

The main contract gives the Employer contractual recourse against the contractor, consultant or sub-contractor if a breach of contract arises. However, the main contract does not offer an incoming third party the same protection. Third parties do not have a contractual link or a commercial relationship as they are not party to the main contract therefore, they cannot enforce said contract.

This is the gap that collateral warranties are meant to fill: they create a contractual relationship between the party responsible for the works or services and a third party, under which the responsible party promises to the third party that it will comply with its obligations under the main contract.

Who should receive a collateral warranty?

Construction projects involve a range of parties with an interest in the development (funders, purchasers, tenants for example). These parties usually require collateral warranties from the construction and design team on a construction project. For example, a tenant will often have a lease on a fully insuring and repairing basis. They will therefore require collateral warranties to allow them to claim against the construction and design team in the event they need to pay for the rectification of a defect.

The step-in option

Some collateral warranties contain “step-in” rights which effectively allow a third party to step into the shoes of another party in certain circumstances, being a party to the underlying main contract to which the collateral warranty relates. Such circumstances include, for example:

• where a contractor has the right to terminate a building contract due to the insolvency or breach of the employer, in which case a party with step-in rights under a collateral warranty from a contractor in favour of a funder (for example) may wish to exercise its right to step-in.
• where a sub-contractor or sub-consultant has the right to terminate a sub-contract or appointment due to the breach or default of the contractor, in which case the employer may wish to exercise its right to step-in under its collateral warranty.