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Collateral warranties: requirements and pitfalls - International Law Office

International Law Office

Construction - Ireland

Collateral warranties: requirements and pitfalls

June 28 2010

Introduction
Key elements


Introduction

A collateral warranty is ancillary to a principal contract. There are usually two parties to a collateral warranty: the warrantor – the party giving the warranty; and the beneficiary – the party receiving the benefit of the warranty.(1) In the construction sector collateral warranties are typically provided by designers, contractors and specialist subcontractors to, for example, a tenant or purchaser acquiring an interest in the property, or a funder financing the development. The collateral warranty provides the beneficiary with a direct contractual remedy against the warrantor where none would otherwise be available. This update summarizes the key elements of a collateral warranty.

Key elements

Primary covenant

A primary covenant is a promise by the warrantor to fulfil the obligations under the principal contract. A beneficiary must have sight of the principal contract, as many of the benefits under the warranty will depend on the terms of that contract. In its simplest form, a warranty must simply state that the warrantor has not broken, and shall not break, its obligations arising under the principal contract.

No greater liability clause
Warrantors may require the primary covenant to be qualified by a provision which states that the warrantor is at no greater risk under the warranty than it is, or would be, under the principal contract. This is known as a 'no greater liability' clause.

The significance of including this clause was demonstrated in Safeway Stores Ltd v Interserve Project Services Limited [2006], in which the supermarket chain Safeway Stores entered into a design and construct contract with Chelverton Properties Limited for a new supermarket and two-storey car park. Chelverton engaged Interserve Project Services Limited to build the supermarket and Interserve entered into a collateral warranty with Safeway that contained the following provision:

"The Contractor shall owe no duty or have any liability under this deed which are greater or of longer duration than that which it owes to the Developer under this Building Contract."

A dispute subsequently arose over defects to the car park. In the meantime, Chelverton became insolvent while still owing Interserve £1.3 million under the main contract. Safeway decided to carry out remedial works to the car park itself and in July 2004 commenced proceedings against Interserve under the collateral warranty, claiming over £400,000 in damages for the costs of the remedial works.

The court found that Safeway was barred from pursuing Interserve under the collateral warranty because of the greater sum owing to Interserve by Chelverton under the main contract. It stated:

"The purpose of Clause 3.3 is clear: it is to restrict Interserve's liability to Safeway to its equivalent liability to Chelverton under the building contract. It still provides a direct route for Safeway to bring proceedings against Interserve, but it ensures that the extent of that liability is no greater than the liability of Interserve to Chelverton."

The reasoning was that had Chelverton gone into liquidation during the performance of the building contract, Safeway could have taken over the main contract subject to first paying Interserve any amounts owing under the main contract. The effect of Clause 3.3 of the collateral warranty was to preserve this situation, such that Safeway could not recover £400,000 from Interserve in respect of the defect unless and until Interserve had been fully paid the £1.3 million due to it from Chelverton.

Net contribution clause
The purpose of a net contribution clause is to transfer to the beneficiary the risk that other parties liable for the same damage may be unable to pay or the risk that they may have ceased to exist. The beneficiary assumes the burden of pursuing such contribution from third parties as may be available. The most aggressive form of net contribution clause is that which defines the defendant's liability in terms of a fair and reasonable share of the total loss. The mildest form of net contribution clause consists of an undertaking by the beneficiary to obtain (or an obligation on the developer to put in place) collateral warranties from other specified parties, usually the other members of the design team and the contractor. There may also be a provision that no action will arise against the warrantor unless other such warranties are obtained.

Step-in rights
Where a bank is funding a development or a purchaser is entering into a commitment with the developer before completion, they will probably require 'step-in rights' entitling them to step-in and take over the development in the event of developer or contractor default. Step-in provisions are usually included in collateral warranties to enable a funder to assume the developer role and complete a project, or to take on the contractor role and adopt the employment of subcontractors (and/or consultants), if either the developer or contractor become insolvent or commit a material breach of the contract.

Assignment
Beneficiaries may require unlimited rights of assignment, although warrantors will generally wish to restrict the number of assignments which may occur. It has become industry standard for a collateral warranty to be assignable once or possibly twice without the consent of the warrantor, with all further assignments being subject to consent.

Duration of collateral warranty obligations
A warrantor must consider the duration of its collateral warranty obligations. In the absence of any express terms which affect the position, the duration of collateral warranty obligations will depend on:

  • when the warranty is entered into;
  • when the development is completed; and
  • the limitation period which applies (either six years or 12 years, depending on whether the warranty is executed under hand or under seal, respectively).

As remedies under collateral warranties are contractual in nature, time starts to run under a warranty from the date of breach.(2)

For further information on this topic please contact Niav O'Higgins and Tristan Conway-Behan at Arthur Cox by telephone (+353 1 618 0000) or by fax (+353 1 618 0618) or by email (niav.ohiggins@arthurcox.com or tristan.conway-behan@arthurcox.com).


Endnotes

(1) Where there are step-in rights, there may be a third party.

(2) Unless, exceptionally, there is an element of wrongful concealment, in which case time will run from the date the breach of duty becomes reasonably apparent.


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