Is a collateral warranty a ‘construction contract’?

What is a collateral warranty?

It is worth considering why collateral warranties became so commonly used in construction projects. If a contractor and employer enter into a building contract together, any beneficiary (such as a landlord or lender) affected by defective design or workmanship, might not be able to recover losses arising from the defects from the employer or contractor, because it is not a direct party to the building contract.

Collateral warranties provide a solution to this problem, and create a direct contractual link between the entity employed under the underlying contract (i.e. the building contractor), sometimes also the employer under that contract, and the beneficiary who has (or will acquire) a material interest in the project to which the underlying contract relates. The beneficiary then has the right to bring a claim against the warrantor for breach of contract if the warrantor breaches the terms of that warranty.

What do the courts say?

This question first appeared in Parkwood Leisure Ltd v Laing O’Rourke Wales and West Ltd [2013] EWHC 2665 (TCC). The court held that a collateral warranty was a construction contract, and as a result, Parkwood had a right under the Act to refer its dispute to adjudication. The court focused on the words “warrants, acknowledges and undertakes” in the collateral warranty, and said that “a warranty often relates to a state of affairs (past or future) … an acknowledgment usually seeks to confirm something. An undertaking often involves an obligation to do something”. In this warranty, Laing O’Rourke warranted, acknowledged and undertook that it would carry out the works in accordance with the contract, it owed a duty of care to the beneficiary in carrying out its duties and responsibilities in respect of the works, and it would regularly and diligently carry out its obligations under the contact.

However, the court held that not every collateral warranty will be a construction contract, and parties needed to consider the wording and factual background on a case-by-case basis. For example, if a contractor warrants to a beneficiary that it will carry out construction operations, that suggests that the collateral warranty is a construction contract, whereas if the contractor warrants that a past state of affairs have reached a certain standard, that suggests that the warranty is not a construction contract.

Parties reacted to Parkwood by amending their collateral warranties to restrict or remove express obligations to carry out construction operations.

The question was raised again in Toppan Holdings Ltd and another v Simply Construct (UK) LLP [2021] EWHC 2110 (TCC). In this case, the contractor “warrants” that it has performed and will continue to perform diligently its obligations under the building contract, and in carrying out and completing the works, it has exercised and will continue to exercise reasonable skill, care and diligence.

As well as the difference in language used, the court also considered the fact that the parties entered into the collateral warranty 4 years after practical completion, and nearly 8 months after the remedial works for latent defects had been completed by another contractor. Indeed, the court commented that they could not “…see how applying commercial common sense a collateral warranty executed four years after practical completion and months after the disputed remedial works had been remedied by another contractor can be construed as an agreement for carrying out of construction operations.”

The court also considered the ‘parasitic’ nature of collateral warranties, a term first coined by Coulson LJ in Coulson on Construction Adjudication (4^th edition, OUP, 2018): “From a broader perspective, if the underlying contract was a construction contract, it makes commercial common sense for any parasitic warranties to be treated in the same way.”

As such, the court held that the collateral warranty was not a construction contract, but commentary suggests that this might be incorrect, as the timing of execution of a collateral warranty is usually a matter of chance, as it is not uncommon for collateral warranties to be completed some time after practical completion.

The Court of Appeal case of Abbey Healthcare (Mill Hill) Ltd v Simply Construct (UK) LLP [2022] EWCA Civ 823 (21 June 2022) is the most recent and authoritative case in this saga, and found that the collateral warranty in this case was a construction contract under the Act. The court interpreted the definition under section 104(1) of the Act broadly, finding that the definition goes far beyond the underlying contract and included agreements ‘related to’ construction operations under section 104(5). The court also endorsed the Parkwood judgment, confirming that it all depends on how the collateral warranty is worded. In Abbey Healthcare, the contractor warranted that it “has performed and will continue to perform diligently its obligations under the contract”, which makes it an “ongoing promise for the future” and “an agreement for the carrying out of construction operations”.

The court also held that because the collateral warranty contained future-facing obligations and was retrospective in effect, the date of execution is irrelevant to whether it was a construction contract. To decide otherwise would have caused uncertainty and would encourage contractors not to sign collateral warranties until after they had finished (which would be unworkable in practice).

However, the Court of Appeal judgment in Abbey Healthcare was not unanimous. In his dissenting judgment in Abbey Healthcare, Stuart-Smith LJ disagreed that section 104(1) should be interpreted broadly. His view of the wording of the contract was that the contractor was simply warranting a state of affairs, rather than agreeing direct obligations to the beneficiary. Many construction lawyers, may find the dissenting judgment a more straightforward interpretation in line with the construction industry’s view of the Act.

Essentially, the Court was agreed (and cautioned against assuming) that all collateral warranties were not construction contracts.

What about third party rights?

As many in the industry will testify, collateral warranties can be troublesome to process, and the more parties to a project, the harder it is to process them. The Contracts (Rights of Third Parties) Act 1999 therefore sought to resolve this by writing the beneficiary’s rights into the underlying contract itself, rather than having them set out in a separate document.

The court held in Hurley Palmer Flatt Ltd v Barclays Bank plc [2014] EWHC 3042 (TCC) that third party rights schedules in an underlying contract will not grant a beneficiary the right to adjudicate a dispute arising under a construction contract. This is because third party rights can only be used to confer rights, not obligations. As such, they only confer a collateral benefit which will not bring them under the remit of the Construction Act.

So maybe an outcome of Abbey Healthcare might be the wider adoption of third party rights in construction contracts, as well as greater standardisation in the drafting of collateral warranties.