Collateral warranties: Understanding their importance and implications

Construction projects are complex ventures with multiple parties involved. Considering the ongoing shortage of housing units, stakeholders are under increasing pressure to complete developments in a timely manner.

Leaving aside the challenges in the construction sector related to inflation, cost of materials and lack of qualified labourers, many developers are also faced with issues associated with the negotiation of contracts. One of the roadblocks that frequently affects completion time is protracted negotiations surrounding the provision of collateral warranties. While lawyers engage in lengthy discussions over the various provisions of the documents, pressure builds on other stakeholders to complete developments and deliver units.

This article provides an overview on the nature of what collateral warranties are, why they are sought and why in many cases they can cause delays.

What is a collateral warranty?

Collateral warranties are legal documents. Simply put, they are agreements between parties involved in a construction project, which create certain obligations. They are typically sought in order to bridge the gap in relationships between the various parties involved, e.g., a purchaser has a contractual relationship with the developer under a building agreement but has no direct relationship with other contractors, sub-contractors, or the professional team. In certain projects, particularly where an entire block or section of a development is being acquired, the purchaser will want to ensure he has a contractual relationship with those parties. A lender providing finance for the development would seek collateral warranties to ensure that they have the power to step into the shoes of their developer borrower and complete the development.

Do we need/want them?

The simple answer is yes. Purchasers typically seek collateral warranties to ensure that they can pursue the various members of the design team where a loss is suffered due to a failure by the consultant to carry out their role with the requisite level of care and expertise, e.g., a purchaser who must vacate a property due to fire safety breaches may seek to recover damages from the consultant who erred in their certification of the property. In the absence of a collateral warranty, this purchaser has no contractual relationship with the consultant and the collateral warranty bridges that gap. The purchaser’s interest typically only arises on completion of the purchase following practical completion of the development. Therefore “step-in rights” are not a feature of purchaser (or lessee) collateral warranties.

“Typically, a lender collateral warranty precludes a contractor from terminating their contract with the developer without first giving notice of their intention to terminate to the lender, who would then have an opportunity to remedy the issue.”

Lenders frequently insist on collateral warranties from the professional team and subcontractors. They are keen to ensure that a development is completed in a timely fashion so that it can be disposed of, and the loan repaid from the proceeds. It is therefore critical that adequate provisions are in place to allow lenders to complete the development when necessary. Unlike purchaser collateral warranties, so called “step-in rights” are a key feature of lender collateral warranties. Typically, a lender collateral warranty precludes a contractor from terminating their contract with the developer without first giving notice of their intention to terminate to the lender, who would then have an opportunity to remedy the issue.

A developer will generally need to co-ordinate the negotiation of a suite of collateral warranties with at least two and sometimes three other parties – the lender, the purchaser and where applicable a lessee (or multiple lessees). For large developments with multiple members of the professional team, the negotiation process can become protracted and frustrating for a developer. They can become little more than a post-box in the negotiations trying to keep their funder, professional team and purchasers happy. A failure to properly manage and co-ordinate this process can be extremely damaging for a development.

Common issues

A large part of negotiating the collateral warranty is focused around agreeing the terms of the liability of the party providing the collateral warranty, and the extent of the liability, both in terms of monetary value and time, and marrying to that a commitment to maintain an appropriate level of professional indemnity (“PI”) insurance.

In recent years uncertainties in the insurance market, combined with the increasing cost of building materials and overall inflation has affected the levels of PI cover available to many contractors. This has led to situations where the PI cover and terms available at the beginning of the project, when the collateral warranty is initially agreed, are no longer available at the time of its execution. This forces the parties involved to re-open negotiations and agree new terms. As collateral warranties are underpinned by the insurance policies, ultimately, the worth of the collateral warranty is dependent on the PI insurance available to each professional.

Conclusion

The average project involves multiple parties – developers, contractors and sub-contractors, architects and engineers, and various consultants to name a few. When insurance providers and their respective legal advisors are added to the mix, the number of parties involved grows exponentially. With so many stakeholders, a re-negotiation of one document will likely have a knock-on effect on the other arrangements in place and sometimes on the viability of the entire development. Not only do the parties to the collateral warranty have to agree updated terms, but the position of other stakeholders also needs to be re-established, leading to significant delays.

Despite the difficulties with collateral warranties, they remain an industry standard to protect the position of interested parties. As the circumstances surrounding the provision of a collateral warranty are different in each instance, a party accepting or providing a collateral warranty should always seek appropriate legal advice. It is important to ensure that parties understand the obligations contained in the documents and the extent to which they will continue to be bound by them into the future.

Joanna Bannon
Senior Associate, Real Estate
joanna.bannon@fieldfisher.com
01 828 0684

Paddy Smyth Partner, Real Estate
paddy.smyth@fieldfisher.com
01 828 0938

www.fieldfisher.com/en-ie/locations/ireland