Collateral warranty

/ March 31st, 2012 / Comments Off on Collateral warranty

What is a collateral warranty?

A collateral warranty is a contractual arrangement that is directly connected to another principal contract. In other words, it is “collateral” to the main contractual arrangement. Collateral warranties are particularly popular in the building industry. Typically, the principal contract is a building contract or agreement with a consultant or sub-contractor. A collateral warranty is normally provided by a person or company appointed under the principal contract (such as the sub-contractor or consultant), and a third party that is not the beneficiary under the main contract, such as a lender or buyer, Although, collateral warranties are nothing more than collateral contracts, it has become customary in the industry to refer to them as collateral warranties. Since, collateral warranties are normally executed as deeds they are also known as duty of care deeds.

Why are collateral warranties executed as deeds?

Executing legal documents as deeds provides additional protection. Firstly, as opposed to standard contractual arrangements, no consideration is required for the contract to be valid. Therefore, the contract executed as deed is perfectly enforceable despite the money not being exchanged. Secondly, the limitation period for bringing a claim is extended from six to twelve years.

What are the advantages and disadvantages of collateral warranties?

Advantages

As most commercial development projects are financed by institutional lenders such as banks, collateral warranties are typically a necessity. Collateral warranty is legally designed to enable a third party with interest in completion of the project to pursue a legal claim against another party involved in that project. Warranties are typically provided by architects, contractors and various engineering companies (i.e. structural or electrical) and give lenders a form of legal recourse in case the project is delayed or stalled completely. It is common for lenders to also negotiate step-in rights along collateral warranties. Step-in rights provide lenders with the right to ‘step into the shoes’ of the developer and sue sub-contractors to ensure smooth completion of the project and recovery of lender’s money.

Disadvantages

Potential for joint and several liability is the main point of concern for those providing collateral warranty. It is perfectly possible that a warrantor could bear the full cost of remedying the defect while in practice being only partially liable for the fault.

Collateral warranties: main provisions

Every collateral warranty should at least cover these core clauses:

  • Standard of care and skill – collateral warranty should require the warrantor to exercise reasonable skill and care. The warranty should also cover any potential breaches of terms that might be contained in the letter of appointment. Ideally, for the beneficiary no other party should be entitled to the same rights under warranty, as this increases the chances of recovery (if more than one party sues this might raise issues of warrantor’s solvency).
  • Insurance – a requirement to maintain insurance at all times is an absolute necessity.
  • Assignment of the warranty – one or maximum two assignments are normally allowed so long as prior notice is given to the warrantor.
  • Prohibited materials – this clause is usually binding on architects who undertake not to include, in the specification, use of prohibited materials.
  • Alternative dispute resolution – it is always prudent for the collateral warranty to refer to alternative dispute resolution in the case of conflict (i.e. conciliation is quite commonly used).
  • Termination of appointment – the collateral warranty must include a minimum notice period to be given by the warrantor before he takes steps to end its appointment.
  • Liabilities – the collateral warranty must not limit other rights and remedies that may be available to the beneficiary under other arrangements (i.e. collateral liabilities). The warrantor should ensure that he is not accepting a great standard of liability then the one imposed by the primary contract.
  • Time period – a collateral warranty is usually enforceable for a period of six year, unless executed as a deed in which case this period is extended to twelve years.

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