What are the differences between collateral warranties and third-party rights?

Although they are similar, collateral warranties and third-party rights should not be confused as one and the same.

But how do you know which is which, and what works best for you? Zi Chuen Gwi, solicitor in our construction and engineering team, explains.

Introduction

Privity of contract in England and Wales prevents a person who is not a party to a contract from enforcing a term of that contract. This means that if you are not a party to a contract, you may not sue or be sued for a breach of contract.

Applying this principle to a construction project means that, for example, only the parties to the building contract may make claims against the other for breach of those terms.

However, in most construction projects, other third parties often have an interest in the works or projects during the construction phase or after the completion of the works, such as tenants, purchasers or funders; how do you protect these parties’ interests if they are not a party to the original construction contract? 

The short answer to this is by putting in place a collateral warranty or providing for third-party rights in favour of third parties with an interest in the project.

What is a collateral warranty?

A collateral warranty is a contract that is “collateral” to the underlying primary contract, such as a building contract, sub-contract or professional appointment.

A collateral warranty is normally given by a party who was employed to provide works/services under the primary contract (such as a contractor, sub-contractor or consultant) to a third party who has an interest in the project. 

The collateral warranty effectively creates a promise made by the relevant contractor, sub-contractor or consultant confirming to the third party that they have complied with their contractual obligations under the primary contract. 

The main purpose is to create a direct contractual relationship between the relevant contractor, sub-contractor or consultant and a third party which enables the third party to bring a breach of contract claim against the relevant contractor, sub-contractor or consultant.

A contract gives a third party an opportunity to claim damages for pure economic loss for breach of contract, such as the cost of making good a defect in the building caused by the contractor, sub-contractor or consultant.

What are third-party rights?

Although there is a general rule of privity of contract in the UK, the introduction of the Contract (Rights of Third Parties) Act 1999 (the “Act”) provided an exception to this rule. 

The Act allows parties to a contract to grant a third party the right to enforce a term, or terms, of that contract, without the need to enter into a collateral warranty. This is generally referred to as "third-party rights".

A third party may enforce a term of a contract it is not a party to, if:

• The underlying contract gives the third party the right to do so; and
• A term of the contract expressly provides a specific benefit on a third party. 

Third-party rights are commonly set out in a schedule to a professional appointment or building contract between the employer and the consultant or contractor and are expressly stated to be enforceable by the third party.

Third-party rights are seen as an alternative to collateral warranties, albeit many parties still prefer to receive collateral warranties.

What are the differences between collateral warranties and third-party rights?

Before the Supreme Court’s decision in Abbey Healthcare (Mill Hill) Ltd v Simply Construct (UK) LLP, one of the differences between a collateral warranty and third-party rights was that collateral warranties could be classified as construction contracts, and parties under a construction contract have a right to adjudicate a dispute under it.  

In contrast, the Act does not provide third parties the right to adjudicate a dispute (unless this right is expressly provided for, in the original contract). 

Since the Supreme Court ruled that a collateral warranty is not a construction contract, this difference between them has fallen away.

Another difference is that third-party rights can become effective with a simple notice, and no specific document needs to be signed by any of the parties. 

This means that parties can reduce a significant amount of admin by relying on third-party rights, as they do not need to go through the process of engrossing and circulating a collateral warranty for signing. This is more cost and time-effective.

Generally, collateral warranties are still perceived as being more effective because they mirror the responsibilities set out in the underlying primary contract. 

There are also concerns about using third-party rights in that the Act does not deal directly with step-in rights or assignment, but these can easily be dealt with by careful drafting. 

Which one should you be using?

The use of collateral warranties over third-party rights  remains the overall preference within the construction industry, especially when funders are involved.

Funders will generally opt for collateral warranties as part of their security package and will not accept third-party rights. 

However, we are starting to see the use of third-party rights becoming more prevalent in certain developments, mainly relating to large mixed-use schemes with multiple purchasers and tenants.

These parties will generally be comfortable with being provided with third-party rights. 

For more information on  collateral warranties and third-party rights, or if you have any questions on construction law in general, please contact Zi using [email protected] or 0191 211 7837.