The Custodian Insurance Industry Blog

October 9, 2018

A Q&A on collateral warranties

A construction project involves many different parties, and with that comes many differing contracts and responsibilities.

What is a collateral warranty?

A collateral warranty is a contract whereby a party to an original contract warrants to a third party that it has complied with its contract; therefore essentially extending the contract.

For example, the Employer and Contractor of a construction project will have a direct contract between them. However, the Contractor may wish to outsource some work to a third party (the Subcontractor). The Subcontractor will then often sign a collateral warranty, creating a direct contractual relationship between the Employer and Subcontractor.

What does it actually do?

As I am sure you are aware privity of contract is a common law doctrine preventing a person who is not a party to the contract from enforcing a term of that contract.

A collateral warranty offers an alternative to this doctrine as it creates a legal contract between parties that would not have existed before. Although this may at first instance seem very useful, clients often overlook the fact that it is often one sided and creates additional liabilities.

Therefore if your client were to sign a collateral warranty this would create an additional contractual link which would have not otherwise existed.  This means a third party will now be able to pursue legal action against your client.

What professions does it affect the most?

Contractors, consultants and subcontractors are among some of the professions which are most affected by a collateral warranty. In many instances the Employer will insist the Contractor enters into a collateral warranty with the Subcontractor so they can bring an action against the sub contractor in the event that the main Contractor were to become insolvent.

Also the buyer is likely to want to enter into collateral warranties with the architect, contractor, construction or project manager in order to benefit from some ‘construction security’ against these professionals in the event that things were to go wrong.

When a business is asked to sign a collateral warranty what are the types of things they need to look out for?

Your client is not legally obliged to sign a collateral warranty unless this was a term agreed in the original contract.   So if its not in the original contract they can refuse to agree to a collateral warranty if they don’t want to.  However often the contract will require this at the outset and a balance needs to be struck between winning new contracts and taking on too many risks.

The most essential thing your client will need to look out for is if the collateral warranty increases liability beyond what would be covered under a professional indemnity policy.  If it is not covered in the insurance policy then they are on their own for any additional liability assumed.

So the following are good things for you client to understand:

  • The number of warranties to be provided and the reasons for those warranties
  • The amount of responsibility expected from them
  • Whether they can limit their responsibility
  • The extent of their liability against cover afforded by their PI cover
  • When their liability will expire
  • The exact parties who are able to bring a claim

Please note that this is not an exhaustive list – just a few pointers.  The key is that their eyes are open and they understand the entirety of what they are agreeing to.

What is its impact on their professional indemnity policy?

If your client is signing the warranty ideally they should aim to keep any liabilities assumed within the scope of their insurance policy.  Otherwise they are not necessarily covered by their PI.

Key points to take away from this article…

  • Collateral warranties are common and often unavoidable when it comes to construction projects
  • Clients are often unaware of the responsibilities involved when agreeing to collateral warranties and whether their agreement is covered by their PI Insurance
  • Clients should always know their position before feeling pressured to enter into a collateral warranty
  • If they decide to enter into a collateral warranty it is essential that they check their insurance policy first and understand the full extent of their liability

Custodian allows up to three assignments in their contractors wording and has also partnered with a law firm to offer a subsidised comprehensive and objective legal checking service on agreements against their PI wordings.

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