Collateral Warranties Explained

Collateral Warranties Explained

A collateral warranty is a contract which runs parallel, and is usually supplemental to, another contract. Usually the purpose of a collateral warranty is to create a contractual relationship between two parties where none would otherwise exist. It takes the form of a contract between the party to the underlying contract who is providing services or carrying out work and a third-party who has an interest in the proper performance of that underlying contract and, just like any contract it must be signed by the Parties to the agreement. The party giving the collateral warranty is referred to as ‘the warrantor’ and the party to whom it is referred to as ‘the beneficiary’.

In England and Wales it is possible to have third-party rights created under the underlying contract itself and in order to create them no separate form of contract is required. This alternative to collateral warranties is now common place in England and Wales and is possible by the enactment of Contracts (Rights of Third Parties) Act 1999 which came into force in May 2000. There is no similar legislation in Malaysia at this time therefore any party wishing to establish a contractual relationship with a party to an underlying contract whom they are not party will have to enter into a collateral warranty with that party.

The legal doctrine of privity of contract means that remedies for failure in performance of obligations under a contract are subject to Contracts Act 1950. For example, under the PAM 2006 Standard Building Contract if no collateral warranty is obtained and a sub-contractor is in breach of his sub-contract, the Employer will not be able to sue him directly for breach of contract as the Employer is not a party to that sub-contract. The Employer would be forced to make his claim against the main contractor with whom he has a direct contract and the main contractor would, in turn have to claim against the sub-contractor. A potential problem for the Employer arises where the sub-contractor’s default does not place the main contractor in breach of the main contract. An example of this would be where a sub-contractor provides late or incorrect design information for work which does not constitute part of the Contractor Designed Works. A similar loss of right to claim occurs where the Contractor is insolvent and the Employer finds he is unable to recover any of his losses from the insolvent Contractor and, without a collateral warranty, he cannot sue the sub-contractor for any breach of contract by him prior to the insolvency.

Where the Employer or indeed a third-party finds himself unable to recover any of his losses as a result of the doctrine of privity of contract it may be able to pursue its claim under the tort of negligence even though the has no contractual link exists. Due to the imprecise nature of case-law in this area and the limited scope negligence covers collateral warranties remain the main method for Employers and third parties to establish a right to recover losses as a result of a party failing in their proper performance of an underlying contract.

As mentioned above, Employers require collateral warranties from the contracting industry in their favour in two different circumstances:

1)   To supplement and reinforce their direct contractual rights by seeking collateral warranties from key sub-contractors and suppliers in respect of materials and workmanship supplied or carried out by them even though he also has contractual rights against the main contractor.

2)   Where the employer may have no enforceable contractual right for the design and construction work where specialist sub-contractors carry out design work in connection with the development, but the main contractor has no responsibility for such design.

Architects and Quantity Surveyors should advise Employers of the risks especially in respect of the second circumstance above where the Architect may be the party who has recommended to the Employer that the design is executed by the specialist subcontractor or nominated subcontractor and after following this advise the Employer is left without any contractual remedy. In such circumstances there may be a good argument that the Architect or indeed Quantity Surveyor have failed in their duty to the Employer by failing to advise the Employer on the need for collateral warranties in respect of these elements of design or alternatively ensuring that the design falls under the Contractors obligations under the Contract.

Similarly purchasers cannot generally sue developers for defects in the development in the absence of express contractual undertakings from the developer. A purchaser who purchases a development or part of such development from the developer (original Employer) would have no direct contractual link with those involved in the construction process unless the benefits of the construction contracts and the various consultancy agreements were assigned to him. Usually this is not possible without the prior consent of the contractor and consultants. This can be overcome by making it a condition of the construction contract or indeed consultancy agreement that the parties consent to such an arrangement but this appears to be rarely the case in Malaysia.  As a result of this, purchasers particularly those with little experience fail to protect their position. As the property market place develops purchasers will become more aware and will require collateral warranties to ensure that they are protected.

A prospective tenant of a new development may require collateral warranties if the lease is to be granted on a full repairing basis, so that the landlord accepts no liability for defects in the building and the tenant becomes liable to carry out repairs at his own cost which is more prevalent in commercial leases. With full repairing leases it is desirable that the tenant obtains collateral warranties from those involved in the construction process in order that he can recover, via a direct contractual link, repair costs from those responsible. Even where the landlord does accept some liability for defects in the building, tenants will usually also want a collateral warranty from the design and construction team in order to protect themselves against insolvency of the landlord developers.

Where a bank or financial institution provides finance for a development and takes a legal charge over the property to be developed, the bank or financial institution will be concerned that at completion the development is free of defects and is of a sufficient quality and value to provide adequate security for the loan it has extended. Without a collateral warranty, a bank or financial institution will have no direct contractual relationship with any of those involved in the design and construction of the development. As a result lenders will usually want a collateral warranty to contain ‘step-in’ rights so that, should the Employer/ Developer default under the financing agreement, or act in such a way that would enable the Contractor to terminate the construction contract, the bank or financial institution can take over the completion of the development and protect its position.

Under traditional forms of building contract such as the PAM 2006 form the main contractor is fully responsible for his own and his domestic sub-contractors, or suppliers, standard of workmanship and for the quality of all materials used but not for any sub-contractor’s or supplier’s design. The main contractor can, moreover, claim loss and expense for delay or errors in the design of sub-contractors unless that design is included in the Contractor’s Design. In circumstances where design is to be carried out by Nominated sub-contractors or suppliers but it cannot for some reason be included in the Contractor’s Designed Portion it is recommended that the Architect refer the matter to the Employer drawing his attention to the need for:.

1)   the sub-contractor to warrant that he has exercised reasonable skill and care in the design of the sub-contract works, in the selection of the goods and materials to be used in the sub-contract works and in the satisfaction of any performance specification set out in the sub-contract.

2)   the Employer to obtain adequate protection in respect of latent defects in workmanship of the sub-contract works after the final certificate has been issued under the main contract;

The contents of a collateral warranty will differ depending upon the underlying contract together with the parties to it and the degree of protection being sought by the beneficiary and those being consented to by the warrantor.

A collateral warranty must impose a contractual obligation on the warrantor in favour of the beneficiary. This is normally done by the collateral warranty referring to the terms of the main contract and the warrantor confirming that they have executed their works in accordance with the Building Contract. This wording reflects the fact that the warrant is intended to be given or at least to be enforced after practical completion has been reached. Under this wording the contractor’s liability under the warranty to the beneficiary will be the same as its obligations under the main contract to the Employer. The contractor’s obligations under PAM Condition of Contract for Building Works 2006 are that the contractor has an absolute duty to complete the contract works in accordance with the contract and specification.

Under contract law economic loss can be recoverable. Therefore, if an Employer suffers a loss of profit, a loss of rent revenue, or a diminution in value in his property due to a breach of contract by a Contractor, he can claim such loss from the Contractor under the contract. Contractors have and should continue resisted the imposition of such all-embracing liability in collateral warranties as this would leave them exposed to possible claims for damages which could not have been envisages at tender time and would not have been included as a contingency or risk within their tender amounts. As a result most collateral warranties limit the contractors or warrantors liability to the reasonable costs of repair only and exclude other losses which may be incurred by the beneficiary whose losses would be unknown to the Contractor or indeed subcontractor.

To make the Contractor responsible for costs of repair and in addition to impose on him further unlimited liability for damages for breach of contract without a cap would have two outcomes the cost of construction would increase drastically due to the possible risks to the Contractor and the likelihood of Contractors turning down to tender in such circumstances would mean some projects would never commence past the drawing board without some kind of compromise. Thus most collateral warranties limit the liability to damages or alternatively limit them to reasonable repair cost.

A further limitation on the beneficiary’s right to claim damages under a fairly drafted collateral warranty from a contractor applies in the case where the contractor is not the only person responsible for the defect. A collateral warranty generally contains a net contribution clause which limits the liability of the warrantor to the proportion of the costs incurred by the beneficiary for which it would be fair for him to pay having regard to his own and the other party’s share of the blame. In which case a clause should be included which states that the Contractor’s liability to the Purchaser or Tenant under the collateral warranty shall be limited to the proportion of the Purchaser’s or Tenant’s losses which it would be just and equitable to require the Contractor to pay having regard to the extent of the Contractor’s responsibility for the same, on the following assumptions, namely that:

1)   The Consultants responsible for the design and or supervision and management of the works have or are deemed to have provided contractual undertakings to the Purchaser or Tenant as regards the performance of his or their services in connection with the Works in accordance with the terms of his or their respective consultancy agreements and that there are no limitations on liability as between the Consultant and the Employer in the consultancy agreements;

2) The respective Sub-Contractors engaged to undertake key works shall have or be deemed to have provided contractual undertakings to the Purchaser or Tenant in respect of design of the Sub-Contract Works that he or they have carried out and for which there is no liability of the Contractor to the Employer under the Building Contract;

3) That the Consultants and the Sub-Contractors have paid or are deemed to have paid to the Purchaser or Tenant such proportion of the Purchaser’s or Tenant’s losses which it would be just and equitable for them to pay having regard to the extent of their responsibility for the Purchaser’s or Tenant’s losses.

This clause operates by assuming that the consultants and subcontractors have a legal liability to the beneficiary, even if in fact the beneficiary has not obtained collateral warranties from those other parties. The purpose of the clause is to entitle the court to calculate what percentage of the blame should be apportioned to those other parties regardless and not leaving the Contractor to be held liable for the other party’s failings.

Under the PAM 2006 form of Building Contract a Contractors collateral warranties will not usually need to contain insurance clauses unless the Contractor is to be responsible for some elements of the design of the works. Where such design obligations exist, they are often required to be backed by professional indemnity insurance. It is important to ensure that the insurance will be available up to the limit stated in the Warranty Particulars for any one claim rather than up to that limit for all claims unless the Warranty Particulars provide for an aggregate limit. The insurance clauses contain provisions requiring the contractor to maintain the insurance for a certain period to be stipulated in the Collateral warranty.

The clauses in the collateral warranty should state that insurance shall be maintained so long as it is available at commercially reasonable rates. This allows Contractors to cease maintaining insurance if insurance premiums rise to an exorbitant level or if restrictions on levels are imposed by insurers. However, the warranty also requires the contractor to notify the beneficiary if such insurance is no longer available.

Where a Contractor is delayed in completing the works under PAM 2006 as a result of the Contractors default the Employer’s remedy lies in liquidated and ascertained damages which may be deducted from monies due to the Contractor in accordance with the provisions of the contract. Cleary, the Contractor does not want to create an alternative remedy for delay which might otherwise by-pass the provisions for liquidated and ascertained damages contained in the contract by giving a collateral warranty under which banks, financial institutions, purchasers or tenants could claim for unlimited damages for failure to complete the contract works within the time specified in the contract. Thus it is normal to include a clause within the collateral warranty which states that the Contractor shall have no liability under the collateral warranty for delays under the contract unless and until such time as the funder (bank or financial institution) the funder initiates the step-in provisions (if any). For the avoidance of doubt the Contractor shall not be required to pay liquidated and ascertained damage in respect of the period of delay where the same has been paid to or deducted by the Employer. This type of clause is normally acceptable to most funders.

Where developments are to be sold, or some other change of ownership is due to take place, it is common for the potential purchaser to request that any existing warranties are assigned to him. Under common law, the benefits of a contract can be assigned unless there is an express prohibition against assignment in the contract. Sometimes, the warrantor may require that assignments be permissible only with his consent, which shall not be unreasonably withheld. Alternatively the warrantor may only allow the assignment of the collateral warranty a limited number of times, for example twice, or to purchasers or tenants of a specified part of the development. The Employer or developer should be advised that, without some ability to assign the warranty at least once or twice, the marketability of a development may be adversely affected as potential future purchasers may be put off if they are unable to obtain the comfort of the relevant collateral warranties.