Collateral Warranties and the Contracts (Rights of Third Parties) Act 1999
I am posting my revision note for MSc construction law and dispute resolution at KCL.
The Privity of Contract
The privity of contract has been a feature of English law since at least the thirteenth century.[1] “The doctrine of privity states, first, that a contract cannot confer rights and secondly that it cannot impose liabilities on anyone except a (contracting) party to it.”[2] It appears to be a logical conclusion in view of the doctrine of consideration, which states consideration must move from promisee to promisor[3]. If consideration is not factored into the relationship between two potential parties to a contract, then a contract cannot be formed. In such a scenario, the third party does not have any rights or obligations. It follows that if you are not a party to a contract, then you cannot sue upon it (no rights) or be sued under it (no obligations). Being unable to impose liabilities on a third party[4] would not be a controversial issue. However, legal issues arise when a contract purports to confer a benefit to a third party, but who is unable to make a claim (when a breach occurs) due to the privity of contract doctrine, consequently resulting in a benefit not being conferred to them.[5]
The doctrine of privity of contract has been subject to judicial criticisms. In the recent case of Darlington BC v Wiltshire Northland Steyn JL stated
“but there is no doctrinal, logical or policy reason why the law should deny effectiveness to a contract for the benefit of a third party where that is the express intention of the party. Moreover, often the parties, and particularly third parties, organise their affairs on the faith of the contract. They rely on the contract. It is therefore unjust to deny effectiveness to such a contract.”
The main criticisms associated to the privity of contract are that: (a) The intentions/purposes of the contracting parties are arguably unsatisfied[7]; (b) It creates an unjust situation to a third party[8]; and (c) The person who has suffered a loss cannot sue, whereas the person who has not suffered a loss can sue (a situation commonly referred to as the ‘black hole’ problem)
Exceptions to the Rule of privity of contract doctrine
Therefore, some exceptions to the basic rule have been developed by the courts. These include: (a) Collateral contracts[9]; (b) Agency; (c) Covenants in land law[10]; (d) Trusts; and (e) Assignment and novation.
The ‘Black Hole’ problem: Who can make a claim?
Based on the doctrine of privity, only a contracting party can make a claim. The problem arises when the contracting party does not suffer damages (referred to as nominal damages), while a third party suffers substantial damages as a consequence of the contract. In such cases, both the contractor and the third party are unable to make a claim for substantial damages. This situation is referred to as a ‘black hole’ problem. In such scenarios, courts have made exceptions to mitigate problems associated with the privity of contract. In St Martin’s Property, the court allowed a contracting party (suffering nominal damages) to make a claim for substantial damages suffered by a third party. Also, in Lindens Gardens v Lenesta Sludge Disposals a subsequent owner was allowed to sue on a construction contract for repairs needed to the building. The decision in St Martin’s Property was affirmed in a subsequent case of Darlington Borough Council v Wiltshire and came to be known as the St Martin’s exception[11].
However, the St Martins exception is strictly limited to cases where a specific set of circumstances are evident, so it is not necessarily clear who is eligible to make a claim in every situation. In Alfred McAlpine v Panatown, a new building owner (UNEX: the third party) suffered substantial damages due to defects within the building, and Alfred (the Contactor) provided a duty of care deed to UNEX, which is not unusual for a construction project. Panatown (the developer) made a claim against Alfred based on St Martins exception. The court held that since a duty of care deed existed, the developer could not rely on the St Martins exception in this particular situation.[12]
Contracts (Rights of Third Parties) Act 1999
As discussed, the privity of contract had been a fundamental feature of English law. The privity of contract, however, was subjected to a great deal of criticism during the 20th century, which culminated in the Law Commission Report No.242: Privity of Contract: Contracts for the benefit of Third parties. The recommendation of this report was implemented by the Contracts (Rights of Third Parties) Act 1999.
Statutory Third-Party Rights
The Contracts (Rights of Third Parties) Act 1999 allows contractual provisions to be enforced by a non-contractual party in certain situations[13] where:
? the contract expressly provides that a third party may enforce a contractual provision;
? the contact term purports to confer a benefit upon him.
Remedy and dispute
Section 1(5) of the Act provides that the third party has available to him any remedy that would have been available to him in action for breach of contract if he had been a party to the contract. The rules relating to damages, injunctions, specific performance and other relief apply in the same way as if he had been a party to the contract. Section 5 prevents the promisor from double liability to both the promisee and the third party. Section 8 the Act provides the third party’s right to proceed to the arbitration under the Arbitration Act 1996.
A variation of the contract[14]
The promised benefit to the third party may not be removed by a variation of the contract if:
? The third party has communicated his assent to a contract’s terms to the promisor;
? The promisor is aware that the third party has relied on the terms;
? The promisor can reasonably be expected to have foreseen that the third party would rely on the terms, and the third party has in fact relied on it.
Limitation of the Act[15]
There are exceptions to the Act. The exceptional circumstances have their own particular remedies hence protection under the Act 1999 is unnecessary. The Act will not apply to:
? A contract of employment; and
? Contracts for the carriage of goods by sea.
? Any incorporation document of a limited liability partnership or any limited liability partnership agreement;
? Bills of exchange, promissory notes and negotiable instruments;
? Statutory contracts that were made under Section 14 of the Companies Act 1985;
? Any incorporation document of a limited liability partnership or any limited liability partnership agreement;
Criticism of the Act
The main criticism centres on the lack of step-in rights for funders. Although the Act can confer the benefits of contractual terms by allowing third parties to step-in, it cannot address step-in provisions which set out obligations on the funder regarding payment as it would be stipulated in the main contract. The lack of step-in rights for funders justifies the use of a collateral warranty and can be overcome by careful drafting and executing any step-in undertakings as a deed, as these would be enforceable without consideration. Assignment is another perceived weakness of the Act as it does not deal directly with it. This can also be overcome by careful drafting a collateral warranty, defining third parties clearly to include all assignees. Also, variations are regarded as one of the weaknesses of the Act 1999. The main contracting parties may need the consent of third parties before doing so. Legal issues arise when the variation is once executed, which some commentators state the Act does allow for this.
In sum, three weaknesses, which are (a) the lack of step-in rights for funders (b) assignment (c) limitation of variations, can be the rationale behind the using a collateral warranty. Construction professionals often prefer the use of collateral warranties over the Act because, apart from the reasons stated above, collateral warranties are seen as tried and tested, with the comfort afforded by a substantial body of legal precedent.
Supporters of the use of the Act preserve a number of reasons why the use of third party rights is preferable to the use of collateral warranties including (a) savings in terms of legal costs and management time; (b) reducing the time taken to close property deals.
The rise of Collateral Warranty
A collateral warranty is a contract ancillary to some other primary contract. The purpose of a collateral warranty is to provide the third party (future owners, successive owners, tenants of the building, and funders) with a cause of action which would not otherwise be non-existent. It is to circumvent the doctrine of privity of contract or secure the duty or care.
In the construction context, series of case laws[16] in the late 20th century established that the contractor does not owe a duty of care in tort to protect the third party from economic loss suffered as a result of defects. The consequence is that without a contractual remedy for defective work the third party does not have a right to claim. It is worth noting that while Murphy and Robinson v PE Jones Contractors may relieve a contractor of liability in tort from successive owners and tenants of commercial buildings but professionals (architects, engineers and other consultants) may still be liable under the rule set out in Hedley Byrne v Heller and Henderson v Merrett. Therefore, a collateral warranty is more frequently used against the contractor rather than professionals.[17] A collateral warranty provides the third party with a cause of action if the defect is attributable to a breach on the part of the contractor. It is notable that the use of a collateral warranty was stimulated by the decision in Murphy and the ‘black hole’ problem.
Features of a collateral warranty
“A collateral warranty is used as a supporting document to a primary contract where an agreement needs to be put in place with a third party outside of the primary contract. Sometimes an architect, contractor, or sub-contractor will need to warrant to a funder, tenant or purchaser that it has fulfilled its duties under a building contract.”[18]
“A collateral warranty often contains obligations that affect the consultant or contractor, such as using materials of an appropriate quality, and carrying out work in a professional, workmanlike manner. Most importantly, it can also provide the third-party contractual rights enabling it to claim for losses which would not otherwise be recoverable.”[19]
A collateral warranty is a contract, therefore, requires the consideration but, most of the collateral warranty is made by a deed. The advantages of the deed are, firstly, no necessity of consideration and secondly, the longer limitation period of the twelve years. On the other hand, when a collateral warranty is made by direct agreement, consideration is still required. The express reference to nominal consideration and acknowledgement of payment (although never actually paid) is frequently included.
Typical Collateral Warranty Provisions are (1) The primary covenant (2) A “no greater liability” provision (3) Prohibited materials (4) Insurance (5) Assignment (6) Copyright (7) Step-in rights (but not always) (8) Further Warranties (9) Dispute resolution.
Assignment
A collateral warranty is assignable. It is considered as one of the advantage using a collateral warranty rather than the Act 1999. Provisions in a warranty may confirm this but are more likely to descriptive to limit the ability to assign. there is usually a restriction on the employer’s ability to assign; often the collateral warranty will provide that two assignments are allowed. Subject to the nature of the works, and whether or not they are likely to be sold often, the warranty may need to expressly provide for assignment more than twice throughout the 12 year period.[20]
Step-in rights
They allow the employer to ‘step into the shoes’ of the contractor if the contractor becomes unable to complete the construction – typically through insolvency. In the current economic climate where contractor insolvency is all too common, this clause can be of great importance. However, the sub-contract/appointment should be drafted to make the exercise of these rights optional: for example, the employer may not wish to insist on stepping in as this may not be financially prudent for the employer depending upon the overall financial position of the sub-contract/appointment.
A person providing funding for development may well require “step-in” rights that allow him to request the warrantor to accept the funder’s instructions (or his nominees) in lieu of those of the original owner or developer.
[1] Ibbetson A historical introduction to the law of obligations
[2] Treitel’s Law of Contract
[3] Tweddle v Atkins
[4] Dunlop v Selfridge
[5] Tweddle v Atkins
[7] Beswick v Beswick
[8] Beswick v Beswick
[9] Shanklin Pier v Detel
[10] Tulk v Moxhay
[11] See also Lindens Gardens v Lenesta Sludge Disposals
[12] Alfred McAlpine v Panatown
[13] S.1 Right of third party to enforce contractual term of the Contracts (Rights of Third Parties) Act 1999
[14] S.2 Variation and rescission of contract of the Contracts (Rights of Third Parties) Act 1999
[15] S.6. the Contracts (Rights of Third Parties) Act 1999
[16] D&F Estates v Church Commissioners [1989] AC 177 HL; Murphy v Brentwood District Council [1991] AC 398 HL; Robinson v PE Jones Contractors Limited [2001] EWHC 102 TCC
[17] (JCT does not issue a Consultant Collateral Warranty. You may wish to consider adapting one of the JCT Collateral Warranties or using other suitable forms.) from https://www.jctltd.co.uk/category/collateral-warranties
[18] from https://www.jctltd.co.uk/category/collateral-warranties
[19] ibid
[20] https://www.penningtons.co.uk/news-publications/latest-news/collateral-warranties-an-overview/