Project Security and Third Party Rights

Question 1

What is a collateral warranty?

Answer 1

A collateral warranty is a contractual link between a third party with an interest in the project under construction and a person who is involved in the design, management or construction of that project. It provides security in the event of defects that arise following construction.

Collateral warranties may also include step-in rights, allowing the beneficiary to step into the role of the client in the event of their insolvency.

Collateral warranties were devised to overcome the problems caused by the principles of privity of contract.

Question 2

What are step-in rights?

Answer 2

Step-in rights usually materialise on the default or insolvency of the developer and allow the funder to step into the shoes of the developer and complete the project without interruption. They are typically included in collateral warranties.

Question 3

What is a bond?

Answer 3

A bond is a promise (usually by deed) whereby the person giving the promise (the bondsman) promises to pay another person (the employer) a sum of money. The bondsman only becomes obliged to make payment when called on to do so.

Question 4

What is a performance bond?

Answer 4

A means of insuring a client against the risk of a contractor failing to fulfil contractual obligations to the client. The purpose of such performance bonds is to provide the Employer with an efficient and fast remedy should the Contractor default in carrying out its obligations under the construction contract.

Question 5

What are the two types of performance bond and what is the difference?

Answer 5

The essential difference between an ‘on-demand’ bond and a ‘default’ bond is that, under an ‘on-demand’ bond, the employer does not have to prove default. Provided that they can show that they have complied with the conditions for ‘demanding’ the bond, the employer can call on it.

This is not true of a default bond where the employer must prove that the conditions necessary to call on the bond have been met. So the effect of providing an on-demand bond (rather than a default bond) is to deprive the contractor of the benefit of all the safeguards built into the contract.

Question 6

How much are performance bonds typically?

Answer 6

An agreed sum of money (usually 10% of the contract sum) payable by the bondsman to the employer.

This compensation can enable the client to overcome difficulties that have been caused by non-performance of the contractor such as, for example, finding a new contractor to complete the works.

Question 7

What is a parent company guarantee?

Answer 7

A parent company guarantee (PCG) is a guarantee provided by the contractor’s ultimate parent or holding company to answer for the failure of the contractor to perform their obligations under the contract.

An employer concerned about a contractor’s financial viability may require a PCG as assurance that the contractor has the financial backing of the (potentially considerably larger) group of companies.

Question 8

What is the difference between a parent company guarantee and a performance bond?

Answer 8

While a parent company may find itself liable for all the losses which a contractor would be liable, the bank or bondsman’s liability under a bond is usually limited to 10% of the contract sum.

While a bond will usually expire at practical completion or the end of the defects liability period, a PCG can last for as long as the contractor is liable under the main contract (usually 12 years post practical completion).

Question 9

What is a retention bond?

Answer 9

For cash-flow purposes, contractors may prefer to provide a security bond in lieu of the employer holding cash retention

The JCT form provides for this and appends a form of retention bond. The contractor is to maintain a bond from the date of possession and, should the contractor fail to maintain a bond, the employer can revert to deducting a cash retention.

Question 10

What are the advantages and disadvantages of collateral warranties?

Answer 10

The advantage is that they provide the security of a contractual link that otherwise would not exist.

However, on large project with many consultant and subcontractors there can be a great number of warranties causing difficulties in completing them. They also require careful wording by a solicitor.

The drafting of these incurs legal fees which will ultimately be pushed back onto the client. Using a standard form of warranty such as JCT will save on these costs

Question 11

Which parties may require collateral warranties?

Answer 11

Any funder

Any purchaser

Any tenant

An employer who may require its contractor to obtain collateral warranties from key subcontractors.

Question 12

Why are collateral warranties more popular than third party rights?

Answer 12

Collateral warranties are familiar, once entered into it is a contract like any other. There is no case law for third party rights.

It may be easier to grant step in rights in the event a borrower (developer) becomes insolvent.

Question 13

What is a net contribution clause?

Answer 13

Net contribution clauses provide that if others are also partly to blame for loss, or have contributed to a loss, then the provider of the warranty will only be liable for an amount that is fair and reasonable having regard to the extent of its blame or contribution.

Question 14

Can a warranty be assigned?

Answer 14

Standard procedure is to allow a warranty to be assigned three times without consent of the warranty provider.

Question 15

What is security?

Answer 15

Security is a financial assurance given by one party to another to ensure the due and proper performance of its obligations under a contract.

Question 16

What rights does the Contracts (Rights of Third Parties) Act 1999 provide?

Answer 16

Enables a third party to assume the benefits of the contract.

Question 17

Does the Contracts (Rights of Third Parties) Act 1999 apply to all contracts?

Answer 17

Yes, although parties can agree that the Act does not apply, and this approach is adopted by most standard form contracts.

Question 18

What is required for a parts to obtain rights via the Contracts (Rights of Third Parties) Act 1999?

Answer 18

Third party must be identified either by name or as a member of a class or by answering to a particular description.

Question 19

When might a performance bond be required?

Answer 19

It will depend on the perceived financial strength of the contractor.

Question 20

What is retention?

Answer 20

Retention is a sum, typically deducted at each monthly payment notice, to provide the client with some security that the contractor/sub contractor will return to correct defects during the defects liability period.

Question 21

What is the default retention amount in the JCT Minor Works and Intermediate contracts?

Answer 21

5%

Question 22

What is the default retention amount in the JCT Standard and Design and Build contracts?

Answer 22

3%

Question 23

Where is the retention amount stated in the contract?

Answer 23

The contract particulars.

Question 24

What is privity of contract?

Answer 24

A common law doctrine which prevents a person who is not a party to a contract from enforcing a term of that contract.

Question 25

What does a collateral warranty protect against the risk of?

Answer 25

In the event that the main contractor becomes insolvent, the chain of contract with the subcontractor who undertook the relevant design work would be broken. A collateral warranty therefore provides a direct contractual link between the employer and the subcontractor.