UK: Collateral Warranties - Time For Change?

Last Updated: 17 June 2005
Article by Clive Lovatt

The Contracts (Rights of Third Parties) Act 1999 has now been in force over five years. It remains a much under used piece of legislation and its application is still specifically excluded from many property development and construction contracts. There are a number of reasons why the Act has received a reluctant welcome. There are other and better reasons why that reluctance should be overcome.

Privity of Contract

As is well known, the Act creates an exception to "privity of contract" – the doctrine that generally a contract cannot confer rights or impose obligations on any person save those who are party to the contract - which has long been central to English law. The point was established as long ago as 1861 in Tweddle v. Atkinson and in 1915 the then Lord Chancellor, Viscount Haldane, delivering his judgement in Dunlop Pneumatic Tyre Company Limited v. Selfridge & Co. Limited said:

"…in the law of England certain principles are fundamental. One is that only a person who is a party to a contract can sue on it."

It should therefore be of no surprise that attempts to amend the doctrine of privity have been slow to come to fruition and slow to gain acceptance. Just how long though is surprising. In 1937 the 6th Interim Report of the Law Revision Committee said:

"We therefore recommend that where a contract by its express terms purports to confer a benefit directly on a third party, the third party shall be entitled to enforce the provision in its own name, provided that the promisor shall be entitled to raise as against the third party any defence that would have been valid against the promisee."

Notwithstanding this, it was not until the Law Commission Report on privity of contract made in 1996 that sufficient momentum was generated for the Act to reach the statute books, with it provisionally coming into force in November 1999 and fully so in May 2000, a full 63 years after the Law Revision Committee's report.

In the interim, English law had been inventive in providing aggrieved parties with remedies. The tort of negligence expanded rapidly through the 1960s and 1970s only to be cut back to first principles by decisions of the House of Lords at the end of the 1980s. In the law of contract, some cracks appeared in the façade of privity of contract with decisions in cases such as St. Martins Property Corporation v. Sir Robert McAlpine and Darlington Borough Council v. Wiltshier Northern Limited. Above all, English law and specifically the property and construction industries, adopted the use of collateral warranties.

Why is use of the Act avoided?

Almost all property and construction lawyers would agree that collateral warranties are often time consuming, difficult and expensive to negotiate and procure. The absence of executed warranties can delay the signing of transactions. Some warranties, for example those given by sub-contractors, can by their nature remain unexecuted many months after the date of the original transaction. The costs of pursuing recalcitrant warrantors can form a significant percentage of the legal costs incurred in a property development or construction project.

Despite this, the operation of the Act is excluded from property and construction documents on many more occasions than its use is adopted. Even projects based on the JCT Major Projects form (the first important new form to be produced by the JCT following the coming into force of the Act) often actually proceed on the basis that collateral warranties will be provided. This is notwithstanding the fact that the standard form produced by the JCT utilises the provisions of the Act.

Why is this the case? When the Act first came into force, a number of commentators expressed concerns that many clauses in commercial contracts could be construed as conferring unintended rights on third parties. It was perceived as "safer" to exclude operation of the Act in total. In addition, and crucially, the attitude to the Act of professional indemnity insurers was unknown.

Five years on, it is clear that the Act can be used effectively and that insurers have few concerns as to the operation of the Act itself (whilst of course remaining concerned as to the nature and extent of the rights confered on third parties). However, the familiarity and certainty of warranties, coupled with the entrenched habits of both legal advisers and their clients have ensured the the continued use of warranties.

Time For Change?

The Act is an effective piece of legislation. Such concerns as to its operation as remain (these are explored in more detail below) can be overcome. The Act offers the opportunity to reduce cost and save time. Most importantly, use of the Act can remove commercial barriers to the closing of property and construction transactions. These advantages should be embraced.

At Addleshaw Goddard, we have sought to do just this. In recent months we have introduced to the property and construction market our initiative under the Act "Three in One Contracting – an end to collateral warranties". At the heart of the initiative are a suite of documents, covering consultants' appointments, bespoke amendments to the principal JCT forms of contract and forms of sub-contract, which incorporate the drafting necessary to make effective use of the Act.

So in a "typical" development project, the usual beneficiaries of collateral warranties still benefit from the protection that a warranty would provide, but instead of receiving a warranty document each beneficiary is instead nominated by service of a pro-forma notice. This is sent by the developer's legal advisers to the relevant consultants and contractors and sets out the identity of the beneficiary, the nature of the beneficiary's interest and the nature of the rights confered upon him.

By way of example, a beneficiary under an appointment acquires the benefit of the duty of care clause under the appointment along with the copyright clause, professional indemnity clause and the prohibited materials clause. Funders obtain the benefit of step-in provisions (about which more is said below).

The position is similar for beneficiaries under the building contract, save that in place of the duty of care clause, the beneficiary acquires the the benefit of the contractor's promise to carry out the works in accordance with the building contract along with (in design and build projects) the contractor's warranty of skill and care in design.

Using the Act

The introduction of Three in One Contracting has raised questions and concerns from consultants and contractors and from beneficiaries. Set out below are some of the more frequently raised concerns along with our approach to the problems raised.

Will there be uncontrolled numbers of beneficiaries?

In the same way as the number of collateral warranties which may be given in favour of any category of beneficiary are normally limited by the principal contract to which the warranty relates, that contract can and should limit the number of beneficiaries who may be nominated to receive rights under the Act.

The risk of confering unintended rights on third parties can be simply avoided by excluding the Act save to the extent that rights are expressly confered on a beneficiary.

What happens to "no greater liability" clauses?

No greater liability clauses are commonly found in collateral warranties. Their purpose is to make it clear that the warranty does not impose a burden which is greater or different to that imposed by the principal contract to which the warranty relates. The wording of such clauses is often the subject of detailed negotiation and construing the effect of completed clauses can be problematical.

Using the Act overcomes these difficulties. The Act states at sections 1(4) and 1(5) that a third party can only enforce a contract term subject to and in accordance with any other relevant terms of the contract and that for the purpose of enforcing a term, the third party has the remedies he would have had if he had been a party to the contract.

How is set-off dealt with?

We have approached set-off in the same way as we would do so in relation to a warranty, namely that a beneficiary should be affected by financial claims by the consultant or contractor against the employer only where that beneficiary has exercised a right of step-in.

What about assignment?

A right given under the Act can be assigned in the same way as any other right under a contract and it is therefore up to the parties to place any commercial limitation on assignment which they wish to see.

What about net contribution?

Net contribution provisions remain amongst the most hotly debated clauses in collateral warranties. If the principle of net contribution is accepted, a net contribution clause can be added to an appointment or building contract, insofar as concerns liability towards any beneficiary.

How long do the third party rights last?

Section 7(3) of the Act amends the Limitation Act 1980 so that a third party's ability to claim under the Act is limited to six years for a simple contract an twelve years for a deed.

How do step-in provisions work?

The Act addresses rights (or benefits) but does not deal in any way with the obligations (or burdens) of a contract . The Act cannot of itself therefore adequately address step-in provisions, which will normally set out obligations as to payment and the continued observance of the terms of the contract by the party exercising the right of step-in.

The problem is easily resolved, however, by specifying that any notice of step-in must be in the form of a deed and must include an undertaking by the relevant beneficiary to pay, or to guarantee payment, in accordance with the step-in provisions of the appointment or building contract.

How does use of the Act affect termination and variations?

The manner in which a contract can be terminated or varied is a matter for the parties to the relevant contract. We have approached our standard documents by making it clear that the contracting parties can exercise a right of termination without needing to obtain the consent of any nominated beneficiary. The exception to this is of course where a beneficiary has been given step-in rights, in which case he is entitled to be given the specified period of notice of intention to terminate.

The employer is in addition allowed to vary the works or any consultant's services without needing the consent of any beneficiary. Any other changes to the terms of any appointment or building contract require the consent of the beneficiaries if any have already been nominated.

Does adjudication apply to the third party?

The threat of adjudication under the Construction Act from a third party beneficiary would be a serious (and probably well founded) concern for many contractors and consultants. It is not, however, a real threat. Section 108 of the Construction Act only confers an entitlement to adjudicate on a party to the contract. Section 7(4) of the Act makes it clear that the grant of third party rights does not make the beneficiary of those rights a party to the contract.

Conclusion

The Act offers benefits in terms of cost and time saving to those involved in property development and construction projects which are difficult to ignore. To the extent that the Act does not resolve issues of importance to the contractors and consultants giving third party rights and the beneficiaries of such rights, those issues can be resolved by careful drafting of the relevant contract provisions.

The questions which have been raised with us since our launch of Three in One Contracting, however, illustrate that the Act and its workings are still unfamiliar to a significant proportion of the property market. The benefits of the Act have been embraced by a number of developers, but others (including importantly banks and others providing property finance) have barely considered its use.

The process of familiarisation is in the hands of the market's advisers and it is a task which we should undertake with enthusiasm.

Cases Cited

Tweddle v. Atkinson (1861) 1 B. & S. 393;

Dunlop Pneumatic Tyre Co Ltd v. Selfridge & Co Ltd [1915] A.C. 847;

St Martins Property Corporation v. Sir Robert McAlpine 57 BLR 57;

Darlington Borough Council v. Wiltshier Northern Limited 69 BLR 1.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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