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19.7COLLATERAL WARRANTIES
An agreement between a sub-contractor and employer (or other party) is known as a collateral warranty because it is collateral to the contractual relations between sub-contractor and main contractor and between main contractor and employer. Warranties from specialist sub-contractors and suppliers are now commonly found on complex building projects, particularly where the sub-contractor or supplier carries out some design or sells proprietary project.
It should not be assumed that a warranty from a sub-contractor or supplier is merely a collection of promises recorded in writing for the benefit of the recipient. In fact, as is invariably found in trade contracts, a warranty can provide the opportunity to the supplier or sub-contractor to define and limit its losses in the event of a breach. Further, as shown below in the instance of the JCT collateral warranty, the warranty may also benefit both parties in the event of termination of the main contract by providing step-in rights to the recipient and guaranteeing direct payment of outstanding sums due to the sub-contractor. Other provisions might address intellectual property, licences or even longer term maintenance matters.
19.7.1Why are warranties sought?
Warranties are rarely volunteered by sub-contractors as, on the face of it, a warranty imposes obligations on the sub-contractor that might be avoided if no warranty was given. The warranty will usually be in favour of the employer or alternatively a funder or a tenant who will occupy the facility. Sometimes subcontractors are asked to provide warranties to each of these groups. In each case the purpose is the same: to provide a direct contractual link between the subcontractor and the other party. This direct link may be needed for either of two reasons:
In general contracting, it is often the case that main contractors do not have design liability. If a specialist sub-contractor has design responsibility for the items being installed, this cannot pass through such a main contractor.
If a main contractor becomes bankrupt, then, in the event of failure or breach on the part of the sub-contractor, the contractual chain is broken, preventing the employer, funder or tenant from having recourse against the defaulting sub-contractor.
For the recipient, the main benefit of a direct contractual relationship with the specialist is that, in the event that liability cannot pass through the main contractor and there is a failure or breach on the part of the sub-contractor, the sub-contractor will be liable in contract to the recipient, depending on terms of the warranty. The real benefit is that the recipient does not have to rely on the law of tort, where a party runs the risk of a finding that no duty of care was owed.
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Funder
Development
contract
Employer
Main contract
Main contractor
Sub-contract
Sub-contractor
Figure 19.1: Chain of contracts
It was, at one point, thought that the need for collateral warranties might fall away as the obligations could be conferred under the main contract under the Contracts (Rights of Third Parties) Act 1999. In practice, it seems parties do not always want to rely on the Act, either because of familiarity with warranties or because there are additional provisions and obligations between the parties required which are more conveniently set out in a separate warranty. Figure 19.1 shows the typical chain of contracts. This connects various parties in a building development project. The problem with this chain of contracts is that any individual party might drop out through insolvency or through not having back-to- back conditions. In such a case, the chain is broken and parties who suffer loss may be unable to seek recourse in contract. Figure 19.2 illustrates how collateral warranties establish contractual links alongside the chain, reducing the reliance on back-to-back terms and on the continued solvency of every firm in the chain.
19.7.2Typical provisions conferred under collateral warranties
Collateral warranties are intended to provide benefits that would not otherwise be available. The various obligations and provisions will depend on the wording of the warranty and depend also on the nature of the party for whose benefit the warranty is drawn. For example, a warranty in favour of a bank or funder will typically include provisions whereby, in the event of the default of the main contractor, the funder takes over the contract or, as it is termed, steps into the shoes
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for reasonable costs of repair, renewal and/or reinstatement of any part or parts of the sub-contract but adds that this is only to the extent that the employer incurs such costs or is liable by way of a financial contribution for such costs. By an optional further provision, the sub-contractor is also liable for any other losses incurred by the Employer up to a limit, if one is stated. This means recovery of unliquidated damages, but the fact that the employer can only claim for a loss suggested that this should not duplicate amounts claimed from the main contractor. The limit can be stated in the warranty particulars as either an amount in respect of each breach, or limited to a capped amount, or that it is unlimited. Clear definition of the consequences of the breach under this clause benefits the employer and subcontractor by providing some certainty over the extent of loss and by affording the opportunity to limit the extent of loss in advance.
Net contribution
In a further provision to limit liability, clause 1.3 seeks to limit the proportion of any loss or damage payable by the sub-contractor to the negligent party’s fair share. It is known as a net contribution clause because, if a loss was caused by actions or inactions of a group of parties, such as partly main contractor, partly sub-contractor and partly engineer, which results in a total or gross loss, the subcontractor is only liable for the part of the loss it caused: its net contribution. The aim of a net contribution clause is to prevent one party ending up bearing responsibility for all losses, even if caused by breaches of a number of parties, on the basis of joint and several liability.
Step-in provisions
On termination of the main contractor, under clauses 3 and 5, the employer can issue directions or instructions in relation to the sub-contract and the sub-contractor agrees to be bound by those instructions. This can be beneficial to both parties. It allows the employer to take over administration of the project, thereby ensuring continuity for the sub-contractor in the event of demise of the contractor during the project. Another benefit to the employer is that by ‘stepping into the shoes’ of the main contractor, the sub-contract does not need to be retendered or renegotiated.
In order that the step-in provisions are effective it is important for the beneficiary of the warranty to have notice in advance of any repudiation or termination that the sub-contractor might exercise. This gives the employer sufficient time to decide whether to step-in. Accordingly, clause 6 of the JCT warranty obliges the sub-contractor to provide such notice in advance of a subcontractor’s termination.
Insurance provisions
It is a common requirement under the warranty for the sub-contractor to maintain insurance cover. Under clause 9 of the JCT warranty, the sub-contractor is to maintain professional indemnity cover or product liability cover with the limits and amounts as specified. This only applies if the sub-contractor has a design function. There is a proviso in that the insurance need only be obtained if available at
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commercially reasonable rates. These provisions provide two advantages to the employer. First, the employer can check direct with the sub-contractor whether any policy is in place and can check policy terms. This is more difficult if there is no direct relationship with the sub-contractor. Second, in the event that no policy is in place, perhaps because the policy cost is excessive, it is open to the employer to take action to ensure policy cover is in place.
Assignment
The benefit of a warranty can be assigned in the same way as any contractual benefit. Warrantors sometimes request limits on the number of permitted assignments in order to limit the number of third parties to whom they may become liable. Clause 10 of the JCT warranty has restrictions on assignment. The first assignment can be made without the sub-contractor’s consent. One further assignment can be made, but will only be effective if notified to the sub-contractor. Thereafter, no further assignments are permitted.
Direct payment
In the event of termination under clauses 4 and 7 of the JCT warranty, the employer is potentially liable, and agrees to accept liability in respect of sums due to the sub-contractor. Even if construction work has finished, this can be of benefit to the sub-contractor where retention money remains due.
Direct payment provisions are said to be for the benefit of employers, since they encourage sub-contractors to tender for work by giving them an extra assurance of payment. However, this added security should not be too heavily relied on, since it is of doubtful value in precisely those circumstances where it is most important, namely, the main contractor’s insolvency. The reasons for this lie in the general law of insolvency (bankruptcy in the case of an individual, liquidation in that of a company). This seeks to ensure that all creditors of the insolvent person are treated pari passu (meaning on an equal footing) and that no creditor receives an unfairly preferential share of the insolvent person’s assets. If, when a main contractor defaults, one sub-contractor receives payment in full (under a direct payment scheme), it is at least arguable that this is unfair preference over other creditors, and also over other sub-contractors who do not have the benefit of such an arrangement.
The main principles by which the law of insolvency seeks to achieve its ends are worth noting. The first point to be made is that, where the main contract does not contain an express provision permitting direct payment to sub-contractors, an employer who makes such a payment will be at risk if the contractor then goes into liquidation. Thus, where an employer paid a supplier of materials immediately after the contractor had gone bankrupt owing money to the supplier, it was held that the employer must pay the money again to the contractor’s trustee in bankruptcy, so that it would be available to all the contractor’s creditors.40
40 Re Holt, ex p Gray (1888) 58 LJQB 5.
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Intellectual property rights
A perennial difficulty for employers is that specialist sub-contractors and suppliers refuse to provide product details which the employer may need for maintenance on completion or even for design of other building components. The sub-contractor’s reluctance is usually said to be because it holds the copyright and does not want the employer to copy the design for use on other similar schemes elsewhere without engaging the specialist again.
As a solution to this issue, under clause 8, the employer is given an irrevocable, royalty-free, non-exclusive licence to copy and use designs for the purposes of the main contract. This is subject to two conditions. First, the sub-contractor must be paid in full all sums due; second, the licence for use is the current project only and so the employer cannot use the data on other projects. Clause 8 is optional. The guidance note to the JCT warranty advises that the option will normally apply where the sub-contractor carries out a design function. It is notable that operation of this clause applies throughout the sub-contract period: it is not dependent upon termination of the main contract.
19.8EMPLOYER SELECTION OF SUB-CONTRACTORS
Nomination is the practice by which an employer, through the contract administrator, selects firms who then enter into sub-contracts with the main contractor. This procedure is found in two ways: in building contracts where the contract administrator asks the contractor to engage a specialist from a list of proposed names who is engaged and has the same status as any other sub-contractor; at the other extreme is where the specialist is engaged as a sub-contractor but the subcontractor also has a special status under the main contract as a ‘nominated subcontractor’ and may have a direct warranty agreement direct with the employer. The latter procedure is in decline in UK building contracts (and now supported in a more limited way in the JCT SBC form) but remains a feature of FIDIC contracts, and may also be seem in some building contracts outside the UK.
The practice of nomination is often said to have developed in order to give the employer control over the quality of sub-contract work, but it also has an important bearing on time and price. As to time, it is often necessary for specialist work to be ordered well in advance, sometimes long before the main contract is let. For tall office structures, for example, the lifts may need to be designed and ordered long before the main contract is tendered. In such circumstances, the employer will order the work and will inform the main contractor at tender stage as to who the sub-contractor is to be. Nomination can also benefit the employer after completion of the work, in that the employer will have the benefit of the particular product or technology provided by the specialist. This can be very important where, as with a lift for example, a long-term maintenance arrangement is required or, in the case of a process plant, the employer is required to used a licenced technology process within the plant.
The foregoing explains how the nomination system benefits employers. In practice it gives rise to difficulties in that the main contractor effectively has no bargaining power when engaging the specialist as a sub-contractor. The result may
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be that there can be significant disputes at tender stage over terms of appointment, particularly if the specialist seeks to exclude all liability for negligence or delay. The second difficulty is that the direct relationship between employer and specialist is lost, once the specialist is engaged as a sub-contractor; unless there is a direct warranty between sub-contractor and employer which is a contractual link (as in Figure 19.2).
In practice there have been two responses to accommodate these difficulties. First, at one extreme, is that construction management (Chapter 6) was developed as an alternative form of contracting whereby the employer has a direct contractual relationship, and direct control, over all specialists and works contractors, and the main contractor is replaced by a construction manager. The second response, at the other extreme, is that nomination has been removed from the JCT standard forms of building contract, and retained only in the sense that the specialist has the same status as any other sub-contractor. The procedure for nomination of a subcontractor must follow the relevant contractual provisions. Common examples are described below.
19.8.1Engaging specialist sub-contractors under JCT SBC 11
The provisions for nomination as set out at clause 3.8 are severely limited. The employer can ask that particular work is carried out by persons from a given list of suggested sub-contractors. The list should have a minimum of three names. The tendering contractor can also add others. If there are fewer than three names, then either an additional name is added by the employer or the contractor is free to engage others to carry out the work. Once appointed, the sub-contractor is treated in the same way as any other sub-contractor.
In the past, nomination involved the use of nomination forms, dedicated warranties and the contract administrator having to note in certificates the amounts allowed in respect of each nominated sub-contractor. The contract administrator also certified extension of time awards for nominated sub-contractors. The effect was that the contract administrator effectively administered those sub-contracts. The result of all this activity was a complex set of rights and obligations that linked employer, main contractor and sub-contractor in a triangular relationship. Further complications arose from the fact that the contract administrator, who had no part to play where domestic sub-contractors are concerned, had a much more important position in relation to nominated sub-contractors. These complications have been swept away by JCT reverting to a position whereby the selected sub-contractor is treated as if it were in the same position as any of the other sub-contractors.
19.8.2Nominated sub-contractors under FIDIC 1999 Red Book
Section 5 of the FIDIC conditions deals specifically with nominated subcontractors, meaning a sub-contractor said in the contract to be nominated, or one which the contractor is instructed to employ during the course of the work.
The nomination process cannot pass without the main contractor’s consent, albeit there are limited grounds upon which an objection to nomination can be
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raised: that the sub-contractor may be of insufficient competence or financial health; that the sub-contractor will not indemnify the main contractor from its negligence; and that sub-contractors will not carry out obligations that are inconsistent with the main contract obligations. An important proviso is that an objection can be released by the employer agreeing to indemnify the contractor against these consequences. The effect of this, in total, is that the main contractor should not be put in a worse position as a result of having to employ this nominated sub-contractor and, to the extent that the contractor might be worse off, the employer indemnifies the contractor for the difference.
Once appointed, the FIDIC conditions make clear, at clause 4.4, that the main contractor remains responsible for the actions and omissions of sub-contractors. The guidance notes to the form indicate that nomination also applies to any subcontractors that might be said to have been nominated under FIDIC.
The FIDIC conditions are significant because the payment provisions are amended specifically to deal with nominated sub-contracts. First, when the engineer certifies the amount due under the sub-contract this should include amounts which the nominated sub-contractor is to be paid by the main contractor. Later, the engineer may ask for proof that the sub-contractor was in fact paid those amounts requested, less any amounts which the main contractor is entitled to withhold, provided those amounts are explained with reasonable evidence. Unless satisfied, the employer may pay amounts direct to the sub-contractor, part or all of which is deducted from future amounts due to the main contactor (clause 5.4).
19.8.3Nomination under ICC 11
The ICC 11 clauses 58 and 59 provide a code of rules for nominated subcontractors and suppliers. First is the contractor’s right of objection to any proposed nomination. In addition to a general right to ‘raise reasonable objection’, clause 59(1) specifically entitles the contractor to refuse any sub-contractor who will not contract on terms which protect the contractor in various ways. If the contractor exercises this right of objection, the situation may be dealt with in a variety of ways. Under clause 59(2) the engineer may:
make an alternative nomination;
vary the works;
omit the item in question and have it carried out by a direct contractor;
instruct the contractor to find a potential domestic sub-contractor and submit a quotation; or
invite the contractor to carry out the work.
The way that ICC 11 (clauses 58 and 59) deals with nominated sub-contractors is of considerable interest. ICC 11 begins by providing that, as a general principle, the contractor is fully responsible for any breach of contract by a nominated subcontractor. This liability is not limited to the amount the contractor succeeds in recovering from the sub-contractor. However, it is qualified to the extent that the contractor cannot be held responsible for matters of design, unless this is expressly stated in both the main contract and the sub-contract.
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Although the contractor is, therefore, fully responsible for the defaults of a nominated sub-contractor while the sub-contract remains in operation, things change once the sub-contract is brought to an end. Provided that termination of the sub-contract takes place with the engineer’s written consent, the contractor’s only obligation thereafter is to ‘take all necessary steps and proceedings as are available to him’ to recover from the defaulting sub-contractor all losses suffered by both the contractor and the employer. To the extent that this proves impossible, it is the employer’s obligation to reimburse the contractor.
19.8.4Defaults of nominated sub-contractors
A nominated sub-contractor has potential liability to the employer in contract and in tort.
Liability in contract
As we saw earlier in this Chapter, the normal contractual structure (consisting of a ‘chain of contracts’) does not provide for a direct claim by an employer against a sub-contractor. However, it is common for nomination procedures to include a requirement that the sub-contractor and the employer should enter into a direct contractual agreement. Where this is done, the agreement is likely to cover such matters as a design warranty from the sub-contractor and a direct payment undertaking by the employer.
In addition to direct contracts that are expressly entered into, there is the possibility that a court may construct (which means ‘invent’) a collateral contract between the employer and a sub-contractor or supplier. This has been done in cases where an employer has been persuaded by certain assurances to nominate a particular sub-contractor or supplier, and the effect is to make those assurances legally binding. For example, in the case of Shanklin Pier Co Ltd v Detel Products Ltd,41 the claimants were about to have their pier repainted. They were assured by the defendants, who were paint manufacturers, that their paint would be suitable for the job, would be impervious to rust and would last for between seven and ten years. On the basis of these assurances the claimants instructed their contractors to purchase and use the paint in question. When the defendants’ claims proved to be wildly optimistic, it was held by the Court of Appeal that they formed the basis of a ‘collateral contract’ between the claimants and the defendants, and that the defendants were accordingly liable in damages for its breach.
In the Shanklin Pier case, the suppliers gave express assurances directly to the claimants, but it seems that a collateral contract may arise without this. In a later case42 it was accepted in principle (though the claim failed on the facts) that suppliers might be made liable on this basis for making extravagant claims about their products in advertising brochures, if these were relied on by employers or their architects in deciding what materials should be specified.
41[1951] 2 KB 854.
42GLC v Ryarsh Brick Co Ltd [1985] CILL 200.
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Liability in tort
Before the decision in 2011 in Robinson v PE Jones (Contractors)43 it was thought that there was generally concurrent potential liability in contrat and tort so that, whether or not there was any direct contractual link between the employer and a sub-contractor, there existed, at least in principle, a potential claim in the tort of negligence. Following Robinson, it is now understood that liability in tort is likely to arise in much more limited circumstances. In so far as such a claim arises out of physical damage (for example, where the sub-contractor negligently causes a fire), it raises identical problems to those discussed earlier in this Chapter in relation to domestic sub-contractors.
The remaining basis upon which liability might arise is where a duty of care is found based on assumption of liability on the part of the sub-contractor. The reliance placed on the sub-contractor by the employer may give rise to a relationship of such ‘proximity’ that the sub-contractor will owe the employer a duty of care in tort not to cause pure economic loss through negligent performance of the sub-contract. This would be most likely to arise if the sub-contractor in question had design responsibility. In the case of Junior Books Ltd v Veitchi Co Ltd,44 where a nominated sub-contractor laid a defective floor in a new factory, it was held on this basis by the House of Lords that the sub-contractor was directly liable in tort to the employer for the costs of relaying the floor and for the consequential loss of production while this remedial work was carried out.
The decision in the Junior Books case came as a shock to the entire construction industry, since there appeared no reason why it should not apply to almost any nominated sub-contract case, thus outflanking what had always been regarded as the barrier of privity of contract. However, the courts in later cases have repeatedly tried to avoid following Junior Books, for example by holding that a tort claim would be inconsistent with any direct warranty which exists between the employer and the nominated sub-contractor.45 Indeed, both the Court of Appeal46 and the High Court47 have even stated that the decision is not binding upon them. All in all, Junior Books might safely be ignored altogether were it not for the fact that, in Murphy v Brentwood DC,48 two members of the House of Lords regarded it with specific approval. Whether this may operate to revive the authority of Junior Books remains to be seen, although it appears unlikely to do so.
In Robinson it was held that a builder owed no duty not to cause economic loss. That case involved sale of a new house that was under construction to the NHBC standards and was subject to sale with the benefit of the NHBC guarantee. Other remedies were excluded with the effect that no assumption of responsibility could be said to have been involved and hence no liability in tort. The court noted that the contractual structure, meaning the absence of a contractual link direct beyond the NHBC guarantee, was a reason for holding that no duty of case arose. The
43[2011] EWCA Civ 9.
44[1983] 1 AC 520.
45Greater Nottingham Co-operative Society Ltd v Cementation Piling & Foundations Ltd [1988] 2 All ER 971.
46Simaan General Contracting Co v Pilkington Glass Ltd (No 2) [1988] 1 All ER 791.
47Nitrigin Eireann Teoranta v Inco Alloys Ltd [1992] 1 All ER 854.
48[1990] 2 All ER 908.
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result, in effective, is that if the parties had the opportunity to put in place a collateral warranty but did not do so, the court will not come to their aid via the law of tort.
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