Collateral warranties: an essential ingredient of a profitable development

It is axiomatic that anyone developing commercial property for investment purposes must let it to a good tenant, at the best rent, and as quickly as possible.  While collateral warranties can hardly guarantee this outcome, their absence can certainly prevent it.

The collateral warranty is one of the most important documents in construction and property.  It is an agreement under which a consultant, contractor or subcontractor (“warrantors” or “design and construction team”) warrants, usually to a lender, tenant or buyer (“third parties” or “beneficiaries”), essentially that it has complied (and if appropriate will comply) with its appointment, building contract or subcontract (“construction agreements”).

The warranty’s chief purpose is to provide security for persons who are not a party to the construction agreements, thereby enhancing the viability and marketability of the development.

The Contracts (Rights of Third Parties) Act 1999 could in theory dispense with the need for warranties, but the construction industry has so far rejected the use of this enactment and most standard-form construction agreements exclude its operation.  [This article was written in 2001, since when the 1999 Act has come into its own and is largely superseding collateral warranties.]

Property agreements and collateral warranties

Property agreements typically require one party to procure collateral warranties from its design and construction team in favour of the other party, sometimes as a precondition of completing the transaction.

Thus agreements for sale and purchase may require the seller to procure warranties in favour of the buyer, before completing the sale.  Agreements for lease may require the landlord to get warranties for the tenant, before completing the lease.  And development and funding agreements may require the developer to obtain warranties for the landowner or lender, before the drawdown of money.

A person covenanting in one of these property agreements to procure collateral warranties in favour of another party must of course be certain that the construction agreements compel the design and construction team to provide those warranties and (in the case of a main contractor) to procure them from subcontractors.

Collateral warranties and assignment

The beneficiary of a warranty will normally insist on being able to transfer (or “assign”) its benefit at least twice to a transferee of its interest in the property (or to another lender refinancing the development).  Unless the warranty can be assigned in this way it may have limited value to the beneficiary, so assignability makes the property more marketable.

A third party, properly advised, would be reluctant to lend money to a developer, or to buy or take a lease of a substantial property, unless it gets assignable warranties from the design and construction team.

Generally, if an agreement contains no prohibition or restriction on assignment each party may freely assign its benefit in the agreement to whomever it pleases, and such assignees may further assign the agreement.

As an alternative to collateral warranties, a developer could assign construction agreements to a third party.  But this would mean that the developer retains no further interest in the construction agreements, so it may not be practicable to assign a construction agreement before works are complete, or to assign construction agreements to (say) a tenant of part of the site: because the developer could not then (a) sue the consultant or contractor or (b) assign the agreement to a tenant of a different part of the site.  Moreover, a lender may require the developer to assign the agreements to him by way of charge, thereby precluding assignments to a buyer before the debt is repaid.

Warranties themselves are frequently assigned.  For example, a developer may hold a contractor’s warranty and subcontractors’ warranties in favour of himself (the latter are usually called employer-subcontractor agreements).  The developer can in turn assign those warranties to a buyer.

Standard-form warranties: a warning

A warranty is only as good as the construction agreement whose performance it warrants.  It follows that the construction agreements, as well as the warranties themselves, must be satisfactory in order to attract funding and ensure the marketability of a property.

As an example of warranties which can fall short of institutional requirements, the standard-form warranties published by the British Property Federation (BPF) and the Joint Contracts Tribunal (JCT), may hamper the letting of a substantial retail unit because they limit the warrantor’s liability in ways which a good retail tenant might well find unacceptable.