Collateral warranties and third party rights on construction projects: a quick guide

A quick guide to construction collateral warranties and third party rights aimed at those seeking to understand collateral warranties and third party rights for the first time.

This is one of a series of quick guides, see Quick guides.

What is a collateral warranty?

On a construction or engineering project, a collateral warranty (www.practicallaw.com/1-107-5937) is a contract under which a professional consultant (such as an architect), a building contractor or a sub-contractor warrants to a third party (such as a funder) that it has complied with its professional appointment, building contract or sub-contract. (See Practice note, Collateral warranties on construction projects (www.practicallaw.com/0-371-6962).)

However, some (weaker) forms of collateral warranty only refer to a "duty of care" or selected obligations under the professional appointment, building contract or sub-contract. (See Practice note, Collateral warranties on construction projects: Key clauses in collateral warranties (www.practicallaw.com/0-371-6962).)

What are third party rights?

A third party right is the right of a person who is not a party to a contract (a third party) to enforce the benefit of a term of that contract. (See Practice note, Third party rights on construction projects (www.practicallaw.com/2-372-2962).)

For example, that could include a right for a funder to enforce a term of:

• A professional appointment entered into between the employer and its architect, engineer or quantity surveyor. (See Practice note, Professional appointments: the consultant's role and appointment (www.practicallaw.com/5-382-8387).)
• A building contract entered into between the employer and its contractor. (See Practice note, Construction standard form contracts: what are they and where can I buy a copy?: What are the main standard form contracts? (www.practicallaw.com/3-502-2528).)

Typically, a construction contract states that a third party cannot rely on the Contracts (Rights of Third Parties) Act 1999 (Third Party Rights Act 1999) unless the contract expressly grants third party rights. Usually, a construction contract that uses third party rights sets them out in a schedule to the building contract or professional appointment.

Why are collateral warranties and third party rights needed?

A construction or engineering project needs collateral warranties or third party rights for three main reasons:

• Privity of contract prevents third parties relying on other people's contracts. Unless you are a party to a contract or section 1(1) of the Third Party Rights Act 1999 applies, you cannot enforce a term of a contract. (See Practice note, Third party rights on construction projects: Section 1 of the Third Party Rights Act 1999 (www.practicallaw.com/2-372-2962).)

• They provide construction security. If something goes wrong on a project, a funder does not want to be out of pocket; it wants to be able to claim its losses directly from the person who caused the loss, such as an architect or a contractor. (See Practice note, Collateral warranties on construction projects: Construction security (www.practicallaw.com/0-371-6962).) Without a collateral warranty or third party rights, a funder may be unable to make an effective claim.

• A claim in tort is unlikely to succeed. The law of tort in England and Wales does not generally allow a claim for pure economic loss, such as damage caused to a building by a defect in that building; you need a contract. (See Practice note, Professional negligence: Pure economic loss (www.practicallaw.com/3-107-4970).)

Who gets collateral warranties or third party rights?

While specific requirements vary from project to project, an employer typically asks its professional consultants and the contractor to agree to provide collateral warranties or third party rights to:

• Any funder.
• Any buyer (often referred to as a purchaser).
• Any tenant (or a given number or class of tenants).

(See, for example, Practice note, Collateral warranties or third party rights: design and build procurement: Diagram: collateral warranties or third party rights and "design and build" procurement (www.practicallaw.com/8-383-2024).)

An employer may also require its contractor to obtain collateral warranties from all the contractor's sub-contractors or selected key sub-contractors.

What is the difference between collateral warranties and third party rights in practice?

In one sense, there is no difference in practice between collateral warranties and third party rights on a construction or engineering project. Either may give effective construction security.

However, collateral warranties remain popular, in part because:

• They are familiar. Historically, construction lawyers are more familiar with collateral warranties. Once a collateral warranty is formally entered into, it is a contract like any other. Even though they have been available for ten years, third party rights are a more recent creation of statute.
• It may be easier to grant step-in rights. If a borrower (such as a developer) becomes insolvent, a funder wants to be able to step in to its shoes to complete and sell the project for the best price. Some argue it is easier to include effective step-in rights (www.practicallaw.com/8-107-7320) in a collateral warranty. (See Practice note, Third party rights on construction projects: drafting issues: Combining third party rights and step-in rights (www.practicallaw.com/2-378-8482).) However, those who prefer third party rights feel it is just as straightforward to grant step-in rights using third party rights (see Blog post, Third party rights - ten years on and the initial nervousness is thawing!).