UK: Methods Of Protection For Lenders, Purchasers And Tenants Involved In Construction Projects And The Impact Of The Contracts (Rights Of Third Parties) Act 1999 On The UK Construction Industry

Last Updated: 11 June 2008
Article by Julian Booth

The Need To Provide Remedies For Lenders, Purchasers And Tenants

Those who provide the finance for a new development or who acquire an interest in it, either as purchasers of the original owner's or developer's interest or as tenants of the completed building, will often be exposed to varying degrees of financial risk in the event of the defective performance by one of the parties involved in the design or construction of the building. Lenders to the developer will require that in the event of a developer's default they should have the ability to realise their security and "build out" of the difficulty, as well as having direct claims against contractors and consultants for their defective performance in the construction process. Potential purchasers may also sometimes need the right to "step in" and secure the completion of the development, and they and tenants will require remedies if, after completion, defects emerge. Also, the original owner may himself need direct remedies against his contractors' and consultants' own sub-contractors.

Since the late 1980's it has been clear that such remedies must be in contract. In D&F Estates Ltd v The Church Commissioners for England [1989] A.C. 177 and Murphy v Brentwood District Council [1991] 1 A.C. 398, the House of Lords removed the possibility of claiming in the tort of negligence for the economic losses (repair/reinstatement costs) flowing from defective building work. As recent developments in tort liability have not resurrected the possibility of tort claims in this context, contractual mechanisms will remain as the sure method of protection for lenders/purchasers/tenants.

Methods Of Protecting Lenders, Purchaser And Tenants By Contract

There are different ways in which protection can be given. Since the late 1980's, the practice has grown of requiring contractors, sub-contractors and consultants to enter into collateral warranties for the benefit of lenders, purchasers and tenants, and sub-contractors to enter into warranties for the benefit of the original owner/employer. Providing collateral warranties has become the industry standard for protecting such parties.

There is also a possibility in some circumstances of the original owner/employer having claims under his contracts for damages to cover losses suffered by third parties such as purchasers and tenants. Sometimes a person with a right against a contractor, sub-contractor or consultant will be able to transfer that right to another beneficiary by assignment. However, such remedies are not favoured and infrequently used.

However, since the enactment of the Contracts (Rights of Third Parties) Act 1999 ("the Act"), which applies (inter alia) to construction contracts, it has become possible for contracts to confer rights which are directly enforceable by third parties. Indeed, one of driving factors for Parliament introducing the Act was to provide a new contractual remedy for the construction industry that dispensed with the problems that had become associated with the practice of providing collateral warranties to third parties requiring protection: the provision of collateral warranties creates significantly more legal documentation, especially on large-scale projects, resulting in increased cost and time to all parties involved in their negotiation and provision, and the non-provision of warranties from key parties in the design and construction of a development can have serious implications as to its commercial value and attractiveness.

The implications of the Act are therefore very far reaching for the construction industry. So what has been its impact?

What Have Been And Will Be The Consequences Of The Act?

The initial reaction to the Act within the construction industry was extremely cautious. Consultants and contractors were reluctant to enter into appointments and building contracts containing third party rights out of fear of inadvertedly granting rights to unforeseen classes of people. The Joint Contracts Tribunal (JCT), the Institution of Civil Engineers (ICE) and the Royal Institute of British Architects (RIBA) all amended their standard documentation to specifically exclude the Act: no professional body wanted to be the first to try and adopt the new third party rights approach in case it did not work, and therefore, both the publishers of the main forms of construction contracts and the professional indemnity insurers decided to approach the Act on a "wait and see" basis.

Over the last five years, however, there has been significant movement from this position. In 2003, the Joint Contracts Tribunal published the JCT Major Projects form which incorporated a schedule of third party rights in favour of a funder, purchasers and tenants. This approach has since been adopted by the JCT in most of their different forms of building contracts, most notably the JCT 05 Design and Build Contract and the JCT 05 Standard Building Contract. Third party rights have also been incorporated in the 2006 version of the British Property Federation (BPF) form of consultant appointment and it therefore appears that the construction industry is becoming more willing to embrace third party rights at the expense of collateral warranties.

Interestingly, much of today's reticence to use third party rights lies with the third parties themselves. Development funders and many anchor tenants prefer the certainty provided by a traditional collateral warranty package. Over time, the construction industry will, in all likelihood, become more comfortable with the Act as various developments are procured with third party rights being the preferred choice of the developing party. This will result in an increased momentum to embrace the Act in the future and a real possibility of third party rights becoming the dominant form of third party protection over collateral warranties.

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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