Are Collateral Warranties Construction Contracts? The Supreme Court Weighs In
July 2024On 9 July 2024, the Supreme Court unanimously decided a collateral warranty is not a construction contract for the purposes of the Housing Grants, Construction and Regeneration Act 1996 (“Construction Act”), and thus cannot be used as the basis for adjudication. In doing so, the Court overturned prior case law.
In this article, Michael O’Brien and Cody Reeves look at the Supreme Court’s judgment and consider its effect on those involved in the construction industry.
Introduction
Collateral warranties give third parties contractual rights against parties with whom they otherwise do not have a contractual relationship. They are a common feature of construction projects – indeed, many parties end up providing them to the ultimate owner/principal/funder, regardless of the procurement method. In the case of contractors (as was the case here), a collateral warranty often gives contractual rights to third parties should defects arise in respect of the works carried out by that contractor.
However, it was unclear whether collateral warranties were “construction contracts” for the purposes of section 104(1) of the Construction Act. If they were, then disputes arising solely out of the operation of a collateral warranty could be referred to adjudication under the Construction Act.
In the present case, the High Court found a collateral warranty was not a construction contract. The Court of Appeal disagreed.
It is against that background that the Supreme Court was asked to consider matters.
Factual Background and Earlier Judgments
As set out in greater detail in our prior article on the High Court and Court of Appeal judgments, this particular case concerned the design and construction of a care home property in north London.
By way of short summary, the contractor (previously known as “Simply”), was engaged under a design and build contract in 2015 with an employer known as Sapphire. The building works were completed in 2016. In June 2017, the building contract was novated from Sapphire to Toppan, the freehold owner of the care home. In August 2017, Toppan in turn granted a long lease of the property to Abbey, which was the tenant/operator.
In 2018, Toppan discovered alleged fire safety defects at the property. Simply was notified and requested to rectify them, which it did not do. A third party ultimately did the works, which were completed in February 2020 and paid for by Abbey.
In September 2020, Simply provided a collateral warranty to Abbey. This came only after Toppan had issued proceedings to enforce a term of the building contract, namely that Simply was required to provide such a warranty to the tenant upon request.
Toppan and Abbey commenced separate adjudication proceedings against Simply, in which they both recovered substantial sums. In the Abbey adjudication, Simply challenged the adjudicator’s jurisdiction on the basis the Abbey collateral warranty was not a “construction contract” within the meaning of section 104(1) of the Construction Act. This challenge was dismissed.
Simply did not pay the sums due, leading Abbey and Toppan to seek summary judgment in the High Court to enforce the adjudication awards. The High Court declined to enforce the Abbey award on the grounds of jurisdiction – in particular, finding that the Abbey collateral warranty was not a construction contract for the purposes of the Construction Act.
Abbey appealed successfully to the Court of Appeal, which considered that the Abbey collateral warranty was a construction contract.
Simply sought, and obtained, permission to appeal to the Supreme Court.
The Supreme Court’s Decision
The Supreme Court, in a unanimous judgment, overturned the Court of Appeal, finding that the Abbey collateral warranty was not a construction contract. The Court reached this conclusion for a variety of reasons.
First, as a matter of statutory interpretation, the Court found that section 104(1) of the Construction Act required an assessment of whether the object or purpose of the collateral warranty agreement was the carrying out of construction operations. If so, then it could come within the ambit of the Construction Act (and therefore be the basis of statutory adjudication).
The Court considered that the purpose of a collateral warranty is normally to grant a third party beneficiary the right to pursue a contractual cause of action in relation to defects and damages arising from previously completed construction works/construction operations. A collateral warranty does not give rise to the carrying out of these operations – that instead falls under the building contract. A collateral warranty that simply promises the third party beneficiary that obligations in the building contract will be performed does not provide a beneficiary any control over how the building operations are performed.
As a result, a collateral warranty of this kind is not an agreement “for” the carrying out of construction operations. Rather, there needs to be a separate or distinct obligation to carry out construction operations for the beneficiary.
Second, as a matter of contractual interpretation, the Abbey collateral warranty merely replicated undertakings that Simply gave to Toppan in the building contract. There was no separate or distinct undertaking for the carrying out of construction operations in favour of Abbey. On this approach, the Abbey collateral warranty was not a construction contract.
Comment
The Supreme Court’s judgment brings welcome clarity on the status of collateral warranties, and confirmation that they generally will not amount to a ‘construction contract’ such that disputes arising solely out of their operation cannot be referred to adjudication under the Construction Act.
However, it does leave third parties (i.e. funders, landlords, tenants – those not in direct privity of contract with those performing construction operations or works) without one potential avenue of recourse in the event defects or other issues are discovered post-completion. As a result, we may now see a change in approach in order to try preserve third party rights. For example:
- A push for third party rights clauses in contracts and appointments in place of collateral warranties, to ensure that it is spelled out in express terms that non-contracting entities do have rights of claim (including adjudication).
- The insertion of contractual adjudication clauses in collateral warranties themselves – once again, to expressly set out that the beneficiary third party has a right of adjudication (albeit under contract, rather than the statutory scheme under the Construction Act).
- Bespoke amendments to contracts and appointments seeking to achieve a form of tag-along claim mechanism – i.e. where the Contractor pursues losses suffered by the third party beneficiary in an adjudication.
It should be remembered that, while the Supreme Court did say its conclusions on the Abbey collateral warranty are likely to mean most collateral warranties are not construction contracts, that did not close the door to every such warranty. Those which contain a separate or distinct obligation to carry out construction operations for the third party beneficiary (rather than simply replicating undertakings in the building contract) may still amount to a construction contract, and give a statutory right to adjudicate and disputes arising from their operation.
It will be interesting to see how parties respond to this judgment, and whether it results in a widespread rethinking of how construction contracts are drafted, and projects organised, in practice.
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