Loved and loathed in perhaps equal measure, collateral warranties have been used in the construction industry for decades. In some respects, these are quite simple documents and not particularly controversial. The industry is comfortable with them and the arguments used during negotiations are well-rehearsed. However, collateral warranties are not without their problems. These primarily concern the fact that in order to be of any use to a beneficiary, a collateral warranty is a separate contract which must be executed.
For smaller projects with a small number of beneficiaries, this does not pose a great administrative burden. However, it can still be problematic to ensure that all parties execute the collateral warranties in a timely manner and that they do so properly. On bigger projects, for instance shopping centres with multiple retail units, and therefore numerous beneficiaries, it can be very difficult to keep up with the demand for collateral warranties and ensure these are all put in place at the appropriate time.
With these issues surfacing on a regular basis, you might think that a simpler, faster and cheaper solution would be welcomed with open arms. However, it is now 17 years since the Contracts (Rights of Third Parties) Act 1999 (“the Act”) came into force and there is still a lingering fear of using the rights set out in the Act. Since 2005, some of the industry standard form contracts have included third party rights provisions. 11 years later, take-up of this option is still very limited, with most parties choosing to amend the standard forms to replace the third party rights with their own collateral warranty requirements.
So what fears loom large in the minds of those preferring collateral warranties and are those fears justified?
• A beneficiary may not be able to adjudicate (see Hurley Palmer Flatt Limited v Barclays Bank Plc  EWHC 3042 (TCC))
• A beneficiary may be able to hinder or prevent the contract from being varied or rescinded
• It may be more difficult to deal with step-in rights
• A lack of case-law and proven track record
The first three of these concerns, while not without merit, are not insurmountable. Careful drafting can deal with each of these points; express provisions can ensure a beneficiary has the right to adjudicate, clear wording can reserve the contracting parties’ rights to rescind or vary the contract and step-in could be made conditional upon a guarantee being provided by the funder to pay the other party following step-in. These issues are dealt with in further detail below.
The right to adjudicate
Hurley Palmer Flatt Limited v Barclays Bank Plc  EWHC 3042 (TCC) was a headline-grabbing case in which Hurley Palmer Flatt (“HPF”) sought a declaration in Part 8 proceedings that Barclays Bank Plc (“BBPlc”) was not entitled to commence adjudication proceedings against HPF and that consequently BBPlc’s notice of adjudication and referral notice were ineffective.
Barclays PLC originally appointed HPF to provide mechanical and electrical engineering services. The appointment allowed for assignment by the bank and for third party rights. A substantial dispute arose, in respect of which BBPlc (accepted as an “Affiliate” of Barclays PLC) commenced adjudication proceedings.
The original appointment included the following key clauses:
Clause 2.3: “Unless expressly stated otherwise in this Agreement, nothing in this Agreement confers or is intended to confer any rights on any third party pursuant to the Contracts (Rights of Third Parties) Act 1999.”
Clause 14.2: “Save as expressly provided in Clause 14.3 and Clause 10 (Collateral Warranties) nothing in this Agreement shall confer or purport to confer on any third party any benefit or right to enforce any terms of this Agreement.”
Clause 14.3: “Any Affiliate with a direct interest in the Project shall be entitled to enforce the terms of this Agreement as “Client” always provided that the Consulting Engineer shall be entitled [to] rely on the equivalent defences in respect of such liability which it has against the Client.”
Clause 27.1: “The adjudication provisions contained in Part 1 of the Scheme for Construction Contracts (England and Wales) Regulations 1998 (S.I. 1998/649) (the Scheme) shall apply to this Agreement.”
It was decided by the Court that the drafting of the contract and in particular the above clauses was such that BBPlc could enforce its rights as a third party relating to the engineer’s liability to Barclays PLC under the appointment but could not rely upon the procedural rights therein, including adjudication. These were expressed in clause 27.1 as applying specifically to “this Agreement”. As a result, BBPlc could not commence adjudication proceedings, its notice of adjudication and referral notice were held to be ineffective and the adjudicator did not have jurisdiction to determine BBPlc’s claims.
This should quite rightly concern prospective ‘third parties’ as adjudication is often the preferred option for pursuing such claims. However, the problem is easily resolved with appropriate drafting expressly permitting those with third party rights to adjudicate to enforce their rights.
Hindrance of variations or rescission
The Act includes the following provision:
Section 2(1): “Subject to the provisions of this section, where a third party has a right under section 1 to enforce a term of the contract, the parties to the contract may not, by agreement, rescind the contract, or vary it in such a way as to extinguish or alter his entitlement under that right, without his consent if-
(a) the third party has communicated his assent to the term to the promisor,
(b) the promisor is aware that the third party has relied on the term, or
(c) the promisor can reasonably be expected to have foreseen that the third party would rely on the term and the third party has in fact relied on it.”
The effect of this is that parties to a contract giving third party rights may be prevented from rescinding or varying the contract in a way that would affect the third parties’ rights without their consent being obtained. This is likely to be unacceptable to the parties to a construction contract or professional appointment.
However, Section 2(3) states:
“Subsection (1) is subject to any express term of the contract under which-
(a) the parties to the contract may be agreement rescind or vary the contract without the consent of the third party, or
(b) the consent of the third party is required in circumstances specified in the contract instead of those set out in subsection 1(a) to (c).”
This means that the parties to the contract can either expressly state in the contract that it can be rescinded or varied without the consent of any other party or can carve out alternative circumstances requiring third party consent which may be less stringent than those set out in Section 2(1) but nevertheless satisfy the third party in question.
Problems with step-in
Collateral warranties for funders normally include step-in rights with some reciprocal obligation upon the funder to pay any sums due to the consultant or contractor in the event that step-in occurs. However, the Act does not allow obligations to be imposed upon a third party. Without the obligation upon the funder to pay any sums due, a consultant or contractor is unlikely to accept drafting granting step-in rights to a funder as a third party.
Again, this is something that should be resolved through appropriate drafting. For instance, the third party rights to step-in could be drafted such that they are enforceable only upon payment of sums due to the contractor or consultant being made by the third party (funder).
Fear of the unknown
The most problematic fear is of course the fear of the unknown – the lack of case-law relating to third party rights and the relatively short period of 17 years since the Act came into force make parties uncomfortable. Funders are also particularly reluctant due to their concerns over step-in.
One other concern falling into this category may be simply the desire to have a physical document on which to rely instead of the less tangible rights within another party’s contract. However, a copy of a warranty is of little value without a copy of the relevant contract or appointment and given the ease with which such documents can now securely be stored in various electronic formats such concerns should be on the wane.
While a lack of case-law can be unnerving, the reality is that even tried and tested methods like collateral warranties can bring unexpected difficulties. The case of Parkwood Leisure Limited v Laing O’Rourke Wales and West Limited  EWHC 2665 (TCC) is a good example of this. For those unfamiliar with the decision, it is one in which the Court was required to determine whether or not a warranty was a construction contract for “the carrying out of construction operations” under the Housing Grants Construction and Regeneration Act 1996 (as amended). The Court decided on the basis of the specific wording in the warranty that it was such a construction contract but made clear that that would not be the case in respect of all collateral warranties in the construction industry. This came as a shock to some beneficiaries who believed their collateral warranties would automatically bestow the right to adjudicate in the event of any liability arising on the part of the contractor or consultant who gave the warranty.
The fact is that there is no evidence to suggest that third party rights are any less effective than collateral warranties and in fact, they may simply be cheaper and less problematic to put in place.
Taking the plunge
Perhaps you have now decided to give third party rights a try. How do you go about this in practice? The clearest and safest way to ensure that the appropriate rights are granted to the correct third party is by way of a schedule to the contract or appointment in question. The Act applies to that schedule but is excluded throughout the remainder of the agreement.
The schedule should identify the third party or parties (either by name or by description) and will set out the entirety of the rights intended to be enforceable by each third party. These rights may of course differ from one party to another and this should be made clear in the schedule. This approach ensures that the contractor or consultant is not giving away any rights beyond those which are intended and which they would have agreed to under a collateral warranty.
There is an alternative approach to the drafting of third party rights which involves amending each clause containing such rights to refer to both the Employer and the third party. This is arguably less practical (particularly where there are multiple third parties with differing rights) and lacks the clarity provided by a separate schedule. A separate schedule also has the advantage of being similar to a collateral warranty in its presentation and may therefore be more palatable to those wary of using third party rights.
It is perhaps inevitable that as third party rights gain acceptance through inclusion in standard form contracts and use by the more daring among you, they will gain traction and one day become commonplace - but I would not be surprised to find the balance still tipped in favour of collateral warranties in 5 years’ time.
These notes have been prepared for the purpose of an article only. They should not be regarded as a substitute for taking legal advice.