Legally Bound

Jordan ...collateral warranties can be used to manage third party liabilities.

Jordan ...collateral warranties can be used to manage third party liabilities.

Making creative use of collateral warranties

STUART JORDAN* discusses how collateral warranties are being used to cover the enforceable rights of project participants that are not party to the contract.

October 2018

Industry standard building contracts, engineering, procurement and construction (EPC) contracts or professional appointments have become ever longer in setting out the bilateral rights and obligations between two parties. But that is only the start of it.

Beyond those contracting parties sits a web of other project participants who may have enforceable rights arising from the operation of that contract even though they are not party to it. Tortious liability and third party rights laws are the main drivers of this.

Generally speaking, the extent of potential exposure to claims from non-parties is less easy to understand, especially in cross-border projects and where the governing law of the contracts is not the same as the local law which applies to certain aspects of its performance. For instance:

• In order to establish claims in tort, the required proximity between two non-contracting persons and the nature of the “duty of care” owed between them, are different in each jurisdiction;

• Also in tort, the limits on recoverable types of losses may be different in each jurisdiction;

• Privity of contract: All jurisdictions recognise privity (the rights of contracting parties to enforce the contract) but countries across the Gulf region also allow for the parties to vest specific enforcement rights in third parties, provided that the third party has a material or moral interest in it – for instance, UAE Civil Code Article 254 and Qatar Civil Code Article 179;

• The rules on civil contribution (what proportion of losses can be claimed from one of several wrongdoers) are not uniform everywhere – and this applies also to contractual liability.

In these situations, collateral warranties can be used to bring clarity. Collateral warranties (or “Direct Agreements”) are now a familiar feature in the contractual set-up of large projects everywhere, including in the Gulf region. We might typically see 10 or more of these created in a project but we don’t often consider the full consequences of giving these warranties or the range of possibilities for what they can be made to do.

The basic function of a collateral warranty is to give directly-enforceable contractual rights to interested third parties, that is, people who have a material interest in the proper performance of a contract but are not party to it.

The most common examples of “interested third parties” are project funders or advance purchasers of the output from the project, such as power purchasers under a long-term offtake contract.

These third parties make early commitments which make the project viable and so, in addition to the contractual recourse afforded in the lending or purchase contracts they signed up to, they require to be the beneficiary of enforceable promises from (usually) main contractors, key subcontractors, design consultants and contract administrators.

Project developers (as employers in main contracts) also sometimes require collateral warranties from key subcontractors.

The core provision in a collateral warranty is (perhaps obviously) the warranty itself: a promise to the beneficiary that the warrantor has complied, and will continue to comply, with its obligations in the underlying construction contract or appointment. This basic warranty places direct legal recourse into the hands of the beneficiary, should the warrantor breach the underlying contract. Oddly, collateral warranties then often contain 20 pages of repetition of those underlying contract terms – pages which add nothing to the core warranty.

We most often think of collateral warranties, therefore, as just a way to expand contractors’ and consultants’ contractual liabilities to benefit third parties. But they can also be used to simplify, limit and better manage those third party liabilities by overlaying contractual connections. For instance, a collateral warranty can provide that the warrantor’s liability shall be no greater than it would be if the beneficiary were joint employer or client in the underlying contract – and allowing equivalent rights of defence, to those available in the underlying contract.

More crudely, but no less effective, liabilities can be capped at a specific sum and limited to certain types of losses or excluding, for instance, tortious liability. The beneficiary’s express rights can be declared the sole and exclusive rights to recover.

To remove potentially onerous contribution risk where several parties are responsible for the same damages, a collateral warranty can include a “net contribution” clause, which limits the warrantor’s liability to an amount which is fair and equitable, taking account of the warrantor’s contribution to the overall damages.

Of course, the effectiveness of these provisions depends on the governing law of the contracts and on what local applicable law will allow as enforceable. Limitations and exclusions of liability especially are vulnerable to public policy restrictions. As always, the legal framework needs to be set up with the benefit of legal advice.

* Stuart Jordan is a partner in the Global Projects group of Baker Botts, a leading international law firm. Jordan’s practice focuses on the oil, gas, power, transport, petrochemical, nuclear and construction industries. He has extensive experience in the Middle East, Russia and the UK.  

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