Supreme Court turns the tables on collateral warranties

Matthew Taylor is a partner and Aidan Steensma is of counsel at CMS Cameron McKenna Nabarro Olswang 

The Supreme Court last week reversed 11 years of law in relation to the existence of a statutory right to adjudicate under collateral warranties. The right depends on whether a collateral warranty is a contract “for … the carrying out of construction operations”, which is the test laid down by the Housing Grants Construction and Regeneration Act 1998 (as amended) (otherwise known as the ‘Construction Act’).

“The assumption will now be that collateral warranties do not fall within the Construction Act”

The general view after the passing of the act was that derivative contracts such as collateral warranties and guarantees wouldn’t be subject to the act. This view was upended in 2013 when the Technology and Construction Court (TCC) (in Parkwood Leisure v Laing O’Rourke) held that a collateral warranty could be subject to the act where it contained language promising that construction work would be carried out in the future under the relevant building contract (something that many, if not most, collateral warranties include).

The Supreme Court has now reversed this position, overruling the Parkwood case and finding that collateral warranties will, in the large majority of cases, not be subject to the Construction Act. In the court’s judgement, the key consideration was not the language of a collateral warranty, but its object or purpose.

For the object or purpose of a contract to be the carrying out of construction operations, it is necessary for the contract to give rise to those operations. A collateral warranty that merely promises that the construction operations undertaken under the building contract will be performed does not do this. It is the building contract that gives rise to the construction operations and the obligations under the collateral warranty merely derive from or reflect those in building contract.

Fundamental change

The Supreme Court’s judgement represents a fundamental change in this area of the law. The assumption will now be that collateral warranties do not fall within the Construction Act, save for special cases where separate and distinct obligations to carry out work are agreed within the warranty. Collateral warranties that contain step-in rights, for example, may fall into this category as and when step-in rights are exercised.

The most immediate impact of the Supreme Court’s judgement will be on adjudication decisions in collateral warranty disputes that have been obtained in reliance on the law as it previously stood. Where no right to adjudicate would now exist based on the Supreme Court’s reasoning, such decisions are likely to have lacked jurisdiction. Any parties that have made payments under these decisions may now be able to claim back those amounts.

The decision is also likely to influence negotiations for collateral warranties and third-party rights on future projects. After the Parkwood case, the statutory right to adjudicate had given collateral warranties a distinct advantage over third-party rights. In 2014 (Hurley Palmer Flatt v Barclays Bank), the TCC decided that the statutory right to adjudicate did not extend to third-party rights and identified difficulties in the holders of such rights taking advantage of express adjudication clauses in the building contract.

The Supreme Court judgement now makes the difference between collateral warranties and third-party rights, as regards statutory adjudication, much more difficult to discern.

As a consequence of this decision, employers and funders may press for the inclusion of express adjudication clauses in collateral warranties. Contractors and consultants may resist this, citing the reasoning in the Supreme Court’s judgement. This may then encourage parties to find ways of securing rights of adjudication through enhancements to third-party rights clauses. Time will tell where the balance will be struck.