Collateral Warranty Guidance

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Collateral Warranty Guidance

If you are a business working in the building and construction industry, you will almost certainly have been asked to sign various agreements and warranties at some point to win contracts. This requires a completely different set of skills – the ability to wade through pages of small print written in a language that only lawyers understand.

Special legal contracts and warranties are a way of life for many firms these days, especially within the construction professions. There are often important insurance implications buried within these documents which require careful consideration and specialist advice.

Inclusive service

Many of the insurance companies we work closely with provide a legal advice service which includes collateral warranties. The service is free to policyholders and the detailed advice will be given by a law firm.

Where the service isn't offered by an insurer, we can normally advise on any PI insurance obligations imposed and, where necessary, involve a specialist lawyer to give a more detailed view and report. The service is included within our overall remuneration and any lawyer's fees are charged separately.

Please contact us for more information.

Guide to Collateral Warranties and Professional Indemnity Insurance

If you are a business working in the construction industry, you may have been asked by your client to sign a collateral warranty at some point, in order to win or retain an important contract. These documents are complex and we recommend that appropriate legal advice is obtained before signing a collateral warranty. Our guide can help to explain some of the main points to consider in the context of your professional indemnity insurance (PI).

What is a collateral warranty?

A collateral warranty is a document normally designed to give contract rights to another party with an interest in a building development, but who has no rights under the main client contract.

You may sign a standard contract agreement with the main contractor and then be asked to extend that agreement by means of a collateral warranty, which gives legal rights to a third party. For example, a third party could be a bank or project financier, the purchaser or another contractor.

If you sign the collateral warranty agreement you will be creating a fresh contractual link that may not otherwise exist. This means you are accepting an additional duty of care to that third party on completion of the project. You may then find that, although you have satisfied the terms of your agreement with your direct client, the third party can make a claim directly against you using the collateral warranty.

Entering into such an agreement can expose you to additional risks which may not be covered by your professional indemnity insurance policy.

Are you covered by your professional indemnity insurance?

By signing a collateral warranty, you may be exposing yourself to a wider range of liabilities than those inherent in the main agreement. This is increasing the insurance risk.

These additional risks may not be covered by your existing insurance policy so if you sign a collateral warranty, do not simply assume your professional indemnity insurance will protect you.

Free legal advice for collateral warranties

Some of the PI insurance companies we work with now provide a free legal support service for their policyholders. This includes a collateral warranty review service with a specialist law firm where they will normally specify what is or isn't covered by the PI policy. This is extremely useful for our clients.

'Noted, subject to the policy terms and conditions'

Most professional indemnity insurers agree, in principle, to provide cover for any claim that arises as a consequence of you entering into a warranty. However, you’ll almost certainly find this is not the case if the duty of care owed to the third party is more onerous and/or of a longer duration than that owed to your direct client as part of your original agreement with them.

If you send the warranty to your insurer (via your broker) to approve, they may respond with the term ‘Noted, subject to the policy terms and conditions’. This simply means they are aware of the warranty, but it is still subject to the existing policy terms and conditions

In other words, if there are clauses within the Collateral Warranty that increase the extent of your liability, and/or extend the period of that liability beyond the terms of the contract with your direct client, then this will probably invalidate the cover provided by your current policy.

These clauses are not easy to spot or understand, so we strongly advise you to contact your solicitors or a specialist insurance broker, before you sign.

Do you really have to sign?

You are not legally obliged to sign a Collateral Warranty unless you agreed to do so under the terms of the original agreement with your client. Go back to your original agreement and check whether you agreed to enter into a Collateral Warranty (a copy of which should be attached to that agreement).

However, even if signing such a warranty was not stipulated in your original agreement, your client may come back and put commercial pressure on you to do so. In this case, you have to make a judgement whether you are happy to sign or not.

If you are obliged to sign the Collateral Warranty because you agreed to do so under the terms of your original agreement, or because you are being pressured to do so and decide to comply, then there are two big points you need to consider:

  • The Collateral Warranty should only refer to those parties specifically included in your original agreement – such as the first purchaser and the first tenant of the development, as well as the funder and any consultants involved.
  • The Collateral Warranty should be a version produced by one of the following organisations:  the British Property Federation, CIC Collateral Warranty or the National Housing Federation. This is important because their terms are readily accepted by most insurers.

Other things to consider before you sign

  • Be clear about the fact that signing a Collateral Warranty will increase your potential liability by adding to the list of potential claimants who are entitled to bring a claim against you.
  • Before you sign a Collateral Warranty notify your broker, who will inform your insurer. If you fail to do this it may invalidate your current Professional Indemnity policy.
  • Because you are increasing your risk you may have to extend your professional indemnity insurance. You’ll need to do this immediately, and the cover must last as long as you are bound by the terms of the warranty. This is generally for a period of 12 years.
  • You’ll need cover up to the value of the Collateral Warranty.
  • Extending your cover will probably increase your premium.
  • If you are planning to retire or cease trading you must purchase run-off cover to comply with the terms of the Collateral Warranty you are agreeing to. Failure to do this could expose the partners or directors to personal liabilities after a business ceases trading.

Clauses you need to watch out for in your original agreement or the collateral warranty

As we’ve already explained, your existing professional indemnity policy will only cover you for certain specified risks and if you expose yourself to additional risks you may find that your policy is invalid with regard to these extra liabilities have accepted.

So before signing an agreement with a client, and before also signing any Collateral Warranty, you need to understand every single clause, as some of them may take you beyond the protection of your policy. In particular, you should look out for the following clauses, treat them with caution, and check with your broker or provider before signing.

Adjudication clauses

Your professional indemnity insurance policy is probably provided on the condition that you do not agree to accept any clause in a warranty which states that you agree to accept the decision of an adjudicator, with no further reference to legal proceedings, arbitration or alternative dispute resolution, in the event of a dispute. If you agree to accept any such clause your insurer may be entitled to refuse cover under your policy for such a dispute.

Indemnity clauses

These clauses seek to make you liable to pay compensation to your client for all losses, claims, damages, expenses and costs caused by a breach of contract or duty on your part when providing your services.  These clauses considerably widen the scope of what your client can recover from you – they go beyond what is normally recoverable at common law.

If you see such clauses you should ask to have them removed from the agreement.  Removal does not disadvantage your client. They can still bring a claim for a breach of contract in the ordinary way.  What’s more, your client will be protected by the fact that you are covered by the professional indemnity insurance that you are required to maintain as part of the agreement.

If your client refuses to remove the indemnity clause, then ask to amend the clause so that recoverable losses are defined as “all reasonably foreseeable, legally recoverable and fully mitigated losses, claims, damages etc.”

Deleterious materials clauses

Check the wording of such clauses to make sure you are only obliged to avoid specifying materials considered deleterious by your profession.  If the wording obliges you to avoid specifying materials considered deleterious within the construction industry as a whole, or by consultants generally, then this extends your liability and may therefore prejudice the cover provided by your policy.  Ask to have the wording changed so that your liability is limited and you are covered.

Fitness for purpose and express guarantee clauses

These clauses are extremely onerous and should be avoided. They impose upon you a duty that goes way beyond the standard terms of “exercising reasonable skill and care” in the performance of your services.

If you accept such clauses, your current professional indemnity insurance policy will not cover you for any contractual liability you incur as a result – so ask for them to be removed.

Likewise, your policy will not cover you for any contractual liability you incur as a result of giving any express guarantee relating to the satisfaction of a performance specification, or that the period of a project or project budget will be achieved, within the terms of your agreement – again, such clauses should not be accepted.

Liquidated damages and penalty clauses

These clauses relate to what happens if there is a breach of contract.  Your professional indemnity insurance policy will not cover you for any contractual liability you incur as a result of agreeing to such clauses and again they should be avoided at all costs.

Need further guidance?

For more detailed advice covering your specific situation please contact us on 0345 251 4000.

Just when you thought that was everything…

One final word of warning. You need to be aware that your professional indemnity insurance policy probably contains specific restrictions relating to Collateral Warranties. These limit the extent to which claims arising from Collateral Warranties will be covered. They vary from one policy to another but you may not be covered if the claim arises from a Collateral Warranty that falls outside the restriction.

We have set out the most common restrictions below, with guidance on how to interpret the wording. Bear this information in mind as you check the terms of your policy, your client agreement, and the Collateral Warranty.

Fitness for purpose / absolute obligations restriction

We touched on fitness for purpose clauses earlier but now we can go into greater detail. Your policy may specifically restrict you from accepting an obligation by signing a warranty which says that what you have supplied will prove fit for purpose – that you guarantee it will definitely work or satisfy a certain standard / specification, come what may.

You should only go so far as warranting that you have exercised reasonable skill and care in the performance of your services.  You should not accept any more onerous obligation than this. If you accept the more limited warranty and then fail to exercise the required skill and care, any claim for negligence that arises is likely to be covered.

If, however, you warrant whatever it is you supply as being fit for purpose, and then for any reason it proves unfit, you will be in breach of contract.  Let’s say you’ve exercised reasonable skill and care but, due to circumstances that are unseen and beyond your control, what you have supplied has not proved fit for purpose. You have not been negligent. However, you are in breach of contract because you voluntarily assumed a higher duty of care than that which is usually expected and which the insurer indemnified you for - so they may refuse to cover the claim.

To avoid falling foul of this restriction, carefully check every clause of the warranty to make sure it does not include this kind of absolute obligation.  It is also a good idea to add the following clause to any warranty you agree to:

“Notwithstanding any other provision in this Warranty or the Appointment, in performing its services in relation to the works, the company shall have no greater duty than to exercise reasonable skill and care”.

Express guarantee of performance or contractual penalty for liquidated damages restriction

Once again, this is an issue we flagged up earlier. Your policy almost certainly restricts you from providing any such guarantee or agreeing to such penalties. Make sure any such clauses are removed from the agreement or warranty before you sign it, otherwise your policy will not cover these additional obligations.

Assignment restriction

Warranties are generally capable of being assigned to a number of other parties. Your Professional Indemnity policy, however, will probably restrict that number to no more than two parties. Be aware that assignment clauses in agreements and warranties often state that assignments between associated/group companies are not to be counted as an assignment. However, Professional Indemnity policies usually make no distinction between associated / group companies and other third parties. You should therefore amend any such clauses to make it clear that no more than two assignments are permitted, regardless of the identity of the assignee.

Here is an example of an assignment clause that should be acceptable to your insurer:

“This agreement may be assigned twice by the Beneficiary by way of absolute legal assignment to another person taking an assignment of the Beneficiary’s interest in the premises without consent of the Client or the company being required, and such assignment shall be effective upon written notice thereof being given to the company.  No further assignment will be permitted”.

DISCLAIMER This guidance note is intended for information purposes only. It is not and does not purport to be legal advice or specific insurance advice. Whilst all care has been taken to ensure its accuracy at the time of writing it is not to be regarded as a substitute for specific advice. If you require specific advice, please contact your insurance adviser. This guidance note shall not be reproduced in any form without our prior permission. © All copyright is owned by Professional Indemnity Insurance Brokers Ltd.