Collateral Warranties: Who Can Rely on the Work When There Is No Direct Contract

Every building is relied on by more people than ever signed a contract to build it. A bank or pension fund lends the money. An investor buys the completed property. Tenants occupy it for decades, and later owners inherit it. If the design was negligent or the work defective, each of these people may lose money: the building may be worth less, need expensive repair, or become unusable for a time. Yet none of them may have a contract with the architect who designed it, the engineer who calculated it or the contractor who built it. The main building contract binds the developer and the contractor. It does not, on its own, give a funder, a purchaser or a tenant the right to sue anyone.

A collateral warranty is the instrument the industry developed to close that gap. It is widely used and widely negotiated, and it is not free. Every warranty signed adds to the liability of the professional who signs it and to the exposure of that professional's insurer.

This comprehensive blog will explore what a collateral warranty is and who typically seeks one, why the absence of a contract matters so much once a building turns out to be defective, and why warranties place a real burden on the professionals who give them and on their insurers. We will examine the alternatives that were already live options, including the 1999 Act and latent defects insurance, and close with the questions that a project team should be able to answer before any warranty is signed. Whether you are a developer, funder, consultant, contractor, surveyor or insurer, understanding who can rely on the work when there is no direct contract is key to closing the gap without pretending the law is simple.

1. A Collateral Contract, Not a Courtesy Letter

A collateral warranty, or more correctly a collateral contract, is an agreement that exists alongside another contract and is related to it. It joins together parties who would otherwise have no contractual relationship, but who are nevertheless involved in the same overall undertaking. It may be made as a deed or as a simple contract. The choice matters: a simple contract needs consideration, and a deed carries a longer limitation period.

Three groups of beneficiaries recur in practice, each with a slightly different reason for wanting a direct link.

The first is the funder, such as a bank or pension fund. A funder may require warranties from the professionals, such as the architect and engineer, and from the main contractor. The aim is twofold. If the developer goes into liquidation or otherwise disappears, the funder wants to be able to require the team to continue with the project. And if defects in the building reduce the value of the investment, the funder wants recourse against those who caused them.

The second is the investor who eventually buys the property, and the tenants who occupy it. They want the benefit of the contracts between the developer and the design team, so an architect may be asked to sign a warranty confirming that reasonable care and skill have been used in the design. Whether that warranty can then pass to later purchasers or tenants depends on any restrictions it contains.

The third is the developer itself, looking down the chain rather than up it. A developer may want warranties from domestic or nominated subcontractors, so that if the main contractor ceases to exist, the project can continue with less disruption because a direct relationship with the subcontractors already exists.

The idea of a collateral contract is older than the modern warranty. Courts sometimes avoided the harsh effects of privity by finding one. In Shanklin Pier Ltd v Detel Products Ltd (1951), the pier owners instructed their painting contractor to use a particular manufacturer's paint after the manufacturer had represented that it would last for years. It failed within months. The contractor had done what it was told and was not in breach, but the court found a collateral contract between the pier owners and the manufacturer about the paint's quality. The device has a limit: a court can find such a contract only where there is evidence for it. A deliberately drafted warranty removes the need to hope for one.

These three groups are illustrations, not a mandatory list for every project. What unites them is the shape of the problem: someone with a real financial interest in the work stands outside the contract under which the work was done.

Because a collateral warranty is a contract, it is not a letter of comfort and not a certificate of good intentions. That has a practical edge. A party that signs a warranty takes on obligations that can be enforced against it by someone it may never have dealt with. There is an equally important qualification from the other side: a warranty creates a contractual relationship that enables the beneficiary to sue, but it does not guarantee that damages will be paid. It is only as good as the indemnity insurance carried by the professional who gives it, or the solvency of a non-professional warrantor.

Figure 1: The missing contractual link: the developer holds contracts with the consultant and the contractor, while the funder, purchaser or tenant has no direct contract with either; a collateral warranty creates a new contractual link across that gap.

2. Why the Gap Matters: Contract, Tort and Economic Loss

If something goes wrong with a building, there are two possible routes to a remedy. A claim in contract alleges that a party failed to meet its obligations under an agreement. A claim in tort alleges that one party's careless act caused damage to another, without any need for a contract between them.

The contract route requires a contract. Under the old rule of privity, only the parties to a contract could claim its benefits or sue on it, and the courts sometimes softened that rule by finding a collateral contract between two of the parties. The privity rule has since been displaced by the 1999 Act, which is considered below. Contract also carries its own limitation periods, six years for a simple contract and twelve for a deed, and its own measure of damages: putting the claimant in the position it would have been in had there been no breach.

The tort route looks more generous, because it needs only a sufficient relationship between the parties. But tort traditionally allowed recovery only for certain kinds of damage: personal injury, and physical damage to other property. It did not compensate for the defective thing itself. If a negligently built building injured someone, or damaged furniture inside it, that loss could be recovered. The cost of repairing the building, the reduction in its value, the cost of renting other premises and the loss of profit while it was unusable were all classed as economic loss.

The law then moved and moved back. The starting point is Donoghue v Stevenson (1932), which laid the foundation of the modern law of negligence: a claim lay for physical harm caused by a contaminated drink, but not for the cost of a replacement bottle, because that was the thing itself. In Dutton v Bognor Regis UDC (1972), a later purchaser succeeded against a local authority over the inspection of foundations, and the damage was treated as physical damage to the house rather than pure economic loss. For a period afterwards, recovery of economic loss in tort expanded, claims in tort proliferated, and claims in contract declined.

Two later decisions reversed that tide. In D & F Estates v Church Commissioners (1988), defective plasterwork had to be replaced, and the question was whether the tenants could recover the cost from the main contractor. The contractor was not liable for its independent subcontractor's negligence on the facts, and the cost of replacing the defective work itself was pure economic loss, not damage recognised in tort. In Murphy v Brentwood District Council (1990), a defective foundation design had been approved by the council, and the earlier approach which allowed such claims was overruled: the loss was purely economic, and a defect discovered before it caused injury or damage to other property gave rise to economic loss only. Together, these cases returned the law to the original orthodoxy, leaving contract as the main medium through which a person can claim for a defect in the building itself.

The courts also showed reluctance to search for liability in tort where the parties were in a contractual relationship, and the decisions on concurrent liability ebbed and flowed. Faced with that uncertainty, it is understandable that employers, funders and purchasers sought warranties, if only "just in case".

The practical point is modest and sufficient. A third party with no contract may not be able to recover in tort the economic loss it most fears, which is the cost of a defective building. That is why a contractual route is sought. Anyone needing the current legal position should consult an up-to-date authority.

Figure 2: Two routes, only one of them secure for the third party: a contractual route through a warranty or a third-party right, and a tort route that is limited for pure economic loss such as the cost of repairing the defective building itself.

3. Warranties Burden the Professional and the Insurer

Every warranty is negotiated between parties with opposite aims. The beneficiary wants it to cover every conceivable situation. The party signing it wants to ensure it does not extend its liability beyond what it would otherwise have carried. And there is a third interest that is easy to forget: the insurer, who will be the party left to field the claim.

The effect is easy to trace. After two decades of growth in negligence followed by its reversal, the response was to seek collateral warranties from all parties involved in a project, irrespective of their function and normal exposure to liability. Members of the design team, not unnaturally, were reluctant to extend their liability to people who would never previously have had a direct contractual link with them. The fairly innocuous warranty of the past became a controversial document.

Standard forms emerged in response, negotiated among bodies representing property owners, surveyors, architects and consulting engineers, with model forms for funders and for purchasers or tenants. Standard forms can, however, be amended to suit one party, which defeats their purpose. Amendments should be considered only after careful professional advice, because insurers' approval is likely to relate to the unamended clauses, and insurers commonly restricted their cover to the obligations under the standard forms.

Several general points explain why the burden is real. A warranty is only worth something if there is adequate insurance or other assets behind it. Insurance generally responds on the basis of the policy in force when the claim is made, so cover that is not maintained may not be there when it is needed. The obligations in a warranty should be no greater than those in the appointment or main contract. And a consultant should be wary of wording that goes beyond reasonable care and skill, for example by warranting that the building is fit for its purpose.

Two features of the standard forms deserve particular attention. First, the consultant's liability is framed as the liability it would have had if the purchaser or tenant had been named as the client under the appointment. That sounds contained, but it leaves open the question of economic and consequential loss: a later purchaser or tenant may suffer foreseeable losses well beyond those the original client would have suffered. Second, a form that allows assignment without a stated limit lets the warranty travel further than anyone first envisaged, and the consultant cannot object. Inserting a limit on the number of assignments is therefore not a technicality; it is one of the main ways a consultant keeps its exposure within what its insurer has agreed to carry.

Beyond these general points, there are particular aspects of a warranty that a professional and its insurer should investigate before signing, especially where the standard form is being varied. They include copyright in the consultant's documents and the limits on their use; step-in or novation arrangements that allow a beneficiary to take the place of the original employer; any fitness-for-purpose obligation; whether the warranty is confined to matters within the consultant's own services; the accuracy of plans the consultant did not prepare; statements about deleterious materials; assignment to later parties; the obligation to maintain professional indemnity insurance; net contribution provisions; and consequential loss. Each is a topic to be examined against the actual draft, not a model clause to be copied, and current warranty forms and current professional indemnity terms should be checked with current advice.

Consider a structural engineering practice that, shortly before a funding deal closes, is sent a funder's warranty to sign by the end of the week. The engineer's appointment was agreed months earlier, and the practice's insurance was arranged on the basis of that appointment. The warranty has been amended from a standard form in ways the engineer has not compared with either document. Nobody has asked the insurer. Whatever the eventual outcome, the first step is obvious: the practice must examine what it is being asked to promise, compare it with the appointment and the policy, and take advice before signing.

Figure 3: A warranty is a new burden, not only a new comfort: a contractual remedy for the funder, purchaser or tenant on one side; additional liability for the professional and exposure for the insurer on the other, with the topics to investigate before signature.

4. The Act and Insurance Were Already Alternatives

The collateral warranty is not the only answer. Two alternatives were already available, and the choice among them remained unresolved.

The first is statutory. The Contracts (Rights of Third Parties) Act 1999 addressed the problem at the heart of privity: parties who wanted their contract to confer a right on a third party could not, under the old rule, give that third party the power to enforce it. In outline, a person who is not a party to a contract may enforce a term of it in his own right if the contract expressly provides that he may, or if the term purports to confer a benefit on him, unless it appears that the parties did not intend the term to be enforceable by him. The third party must be identified in the contract, by name, as a member of a class or by description. The Act applies to England, Wales and Northern Ireland, to contracts made on or after its commencement, and it also contains provisions on variation of the contract, the defences available against a third party, and protection against double liability. The detail of those provisions, and how they apply to any particular contract, is a matter for the Act itself and current advice.

The industry's response was cautious. It was possible to exclude the Act altogether, and for some years this was the most common approach, because it avoided the risks and uncertainties of a new statute. Many professional indemnity insurers initially adopted a wait-and-see approach, and standard-form drafting bodies, including the JCT, excluded the Act in their documents. A compromise was possible: allowing certain clauses to be relied on by a third party without opening the whole contract. Alfred McAlpine v Panatown, decided in 2000, shows why the choice of route matters. A building contractor had given a duty of care deed, a form of collateral warranty, to the company that owned the land, and the House of Lords held that the contracting party could not recover for the owner's loss because the owner had its own direct remedy under that deed. Proper use of the Act should prevent such "legal black holes". The Act may not have ended collateral warranties, but it may yet prove to be the beginning of the end.

The second alternative is insurance of the building itself. Latent defects insurance is an idea brought to the UK from France, where such cover had long been required. In outline, such policies cover physical damage to the property caused by an inherent defect in design, workmanship or materials notified during the period of insurance, and the insurer requires its own technical inspection. Its attractions are that it is damage insurance that does not depend on proving fault by anyone, that it can pass to successive owners and protect tenants, and that early technical audit may detect defects before completion. Cover typically extends to resultant damage to other elements of the insured building, including the cost of reaching and reinstating them, and tenants may be able to arrange separate business interruption cover to suit their own needs. Policies also carry limitations and excesses, and the terms of any real policy must be read in that policy.

Bonds, guarantees and retention are further forms of contractual security. They are different instruments with different purposes and are not considered here.

The overall picture deserves to be stated plainly. Collateral warranties were widely accepted as the traditional method of protecting parties' contractual positions, but they could place a serious liability burden on the professional team and their insurers. Even with the 1999 Act, practice had not settled on the most practicable way of achieving satisfactory protection. Whether the industry would keep the warranty, shift towards building-related insurance, or warm to the Act was an open question, and the position today must be checked against current law and current market practice.

Figure 4: Three routes to a third-party remedy: a collateral warranty, a right conferred under the Contracts (Rights of Third Parties) Act 1999, and building-related or latent defects insurance; practice had not settled on one.

5. What to Ask, and What to Leave to Advice

The analysis above supports a short set of questions. They are a practical aid, not a validated clause checklist, and they deliberately stop where specialist legal and insurance advice must take over.

1. Who wants to rely on the design or the work, and do they already have a contract with the person who produced it? A funder, purchaser, tenant or developer looking down the supply chain may each have a different reason for asking, and the reason shapes what they actually need.

2. If they do not have a contract, is a contractual link being created, or is an insurance route being used instead? The link might be a collateral warranty or a right conferred under the 1999 Act. Alternatively, the parties might rely on latent defects insurance of the building. These are different instruments with different strengths, and they are not interchangeable by default.

3. Have the professional and the insurer actually examined the additional burden? The agenda set out above is a useful prompt: copyright, step-in, fitness for purpose, the limits of the warrantor's own services, plans and materials statements, assignment, insurance obligations, net contribution and consequential loss. The question is not whether each topic has a "standard" answer, but whether it has been looked at before signature, and whether the insurer has agreed.

4. Is the choice being made consciously? The 1999 Act did not end disagreement about the best route, and many contracts excluded it. A team that excludes the Act, asks for warranties and ignores insurance may be making the right choice, but it should be a choice, not a habit.

5. Which questions require current legal and insurance advice? The case law traced above reflects its time. Warranty forms, professional indemnity terms, the use or exclusion of the Act, and insurance products have all moved on and must be checked with current sources.

Returning to the engineering practice, the aid does not tell it what to sign. It tells it what to do before signing: identify who is asking and why, recognise that a warranty is being requested rather than a third-party right or an insurance alternative, compare the amended terms with the appointment and the policy, consult the insurer, and take current advice on anything the practice cannot answer itself. If the deadline does not allow that, the honest answer is that the warranty is not ready to be signed.

A developer looking down the chain can use the same questions. If it wants warranties from key subcontractors so that the project can continue should the main contractor fail, it should be clear which subcontractors matter for that purpose, whether their design responsibilities justify a direct link, and whether the subcontractors' own insurance can support what is asked. A warranty from a party with no meaningful cover or assets may add paperwork without adding much protection.

The questions also work in the other direction. A funder or purchaser who asks for a warranty should understand that it is buying a right to sue, not a guarantee of payment, and that the value of that right depends on the warrantor's insurance and on the terms actually agreed. Asking for terms that no insurer will cover may produce a document that looks strong and is worth very little.

Conclusion

A person who relies on a building may have no contract with those who designed or built it. That gap matters because tort, after a sequence of cases that first widened and then narrowed recovery, does not ordinarily compensate a third party for the economic loss of a defective building itself. Contract does. The collateral warranty is the instrument that creates the missing contract: an agreement alongside the main contract that joins parties who would otherwise have no direct relationship, typically funders, purchasers, tenants and, looking down the chain, developers seeking links with subcontractors.

The warranty is not a courtesy. It burdens the professionals who give it and the insurers who stand behind them, which is why its terms are negotiated so carefully and why each significant aspect deserves investigation before signature. It is also not a guarantee: it gives a right to sue, worth only as much as the insurance or assets that support it.

Nor is it the only route. The Contracts (Rights of Third Parties) Act 1999 offered a statutory way of conferring enforceable rights on third parties, though it was commonly excluded in its early years. Latent defects insurance offered protection for the building itself without the need to prove anyone's fault. Practice had not settled on one answer.

The discipline, then, is a conscious choice among warranty, statute and insurance, made by parties who understand what each provides and what each costs. One caution applies throughout: the case law, forms and market practice described here are those of UK construction in the 2000s. Current law, current standard forms, the current use of the 1999 Act and the current insurance market should all be checked before any of it is relied upon.