Debentures, legal charges, directors’ personal guarantees and can be used to give funders very extensive rights of security, so why are collateral warranties also required as part of a comprehensive security package for development financing?
For the funders and institutional investors for whom Wright Hassall acts, warranties in their favour are a vital form of protection. They also provide a useful practical function as they can be used to provide the funder with step-in rights, allowing it to step into the shoes of the original employer/client during the construction of the development.
Most of our developer clients appreciate that warranties are a precondition to their development finance. It is always useful however for the parties to understand why they are necessary in the first place. Our aim on any development is to work with a developer from first instruction to ensure that it has the contractual right to procure the necessary collateral warranties from its design and contractor teams.
What do they do?
A funder who lends money to a developer to construct a development has no contractual interest in, for example, the underlying building contract, which is entered into between solely the developer and its contractor. This is doubly so given that the underlying contract will usually exclude the operation of the Contracts (Rights of Third Parties) Act 1999. Consequently the funder would not be able to claim rights under that contract to which it is not a party, even though it has an interest in the subject matter of the contract. A collateral warranty is a collateral agreement to the underlying contract and creates a contractual link between a funder and the parties (in particular the contractor, as warrantor) to that contract.
From whom are they required?
Collateral warranties are normally requested from a building contractor, the employer’s and contractor’s design team, and sub-contractors (usually those sub-contractors with material design responsibility, or those responsible for bespoke and/or high-value sub-contract works packages).
What do they provide?
A well drafted warranty will contain clauses which mirror some of the main provisions of the underlying contract. Collateral warranties provide a beneficiary with a warranty from the warrantor that it has fulfilled, and will continue to fulfil, its obligations under the underlying contract and in particular that it will carry out any design with reasonable skill and care. They also create contractual rights and obligations between the warrantor and the beneficiary in respect of, for example, copyright (use of drawings), insurance (allowing funder claims on the contractor’s insurance) and assignment (may be limited to a particular number by the beneficiary).
In the event that the funder elects to finish a troubled development (whether due to developer insolvency or breach of the finance agreements), step-in rights are the mechanism which allows the funder to do this. The option to step-in is however only a ‘right’ of the beneficiary, not an ‘obligation’.
If step-in occurs the beneficiary will take responsibility for any past and future unpaid sums under the contract. Step-in provisions also often try to postpone the exercise of the warrantor's rights to terminate the underlying contract – in order to give funders time to react and to make sure that they have the opportunity to consider whether or not to exercise their right to step-in.
Limitations of liability
Warranties usually contain ‘no greater liability’ and ‘equivalent rights of defence’ clauses, which are acceptable if properly drafted. Their inclusion in a warranty emphasises the need to check for caps and limitations in the primary contract, not just the warranty.
Other caps on liability are acceptable within reason but must be appropriate to the level of foreseeable loss in the event of a claim.
Net contribution clauses
These clauses often state that where two or more warrantors on a development are each jointly liable for the same defect, the liability of each warrantor will be limited to the amount which would be just and reasonable having regard to their contribution to the defect. In practice this transfers the burden of pursuing the other defaulting parties for their contribution from the warrantor to the beneficiary.
Currently the market recognises that institutional investors and funders will not accept such limitations. The rationale for their unacceptability is that such clauses effectively act to limit recoverability of a beneficiary’s losses in the event that one or more of the defaulting parties is insolvent.
In conclusion, a funder is recommended to:
- check that the building contract and appointments are in place and that they provide for warranties in its favour;
- ensure that the form of warranty is as favourable as possible with no limitations on liability or exclusions; and
- make the provision of key warranties a condition precedent to draw-down,
and a developer is recommended to:
- engage with its supply chain early and put in place agreements from designers, the contractor and sub-contractors, which allow for warranties for all likely beneficiaries; and
- ensure that warranties are procurable in favour of a wide class of beneficiary.