Collateral damage: Liability under collateral warranties

We are often told that collateral warranties should be relegated to a footnote in the law books, but the truth is that they are as important as ever - and subject to increasing judicial scrutiny. Tony Bingham recently drew attention to a case concerning the new head office for Scottish Widows, which gave rise to some novel legal issues (23 April, page 50).

Claims relying on collateral warranties are frequently made by tenants or buyers who discover defects long after they have taken occupation. An unusual feature of the Scottish Widows case was that the serious defects that gave rise to the litigation were known about before practical completion and well before the affected leaseholder purchased their interest.

The consultant and contractors that had given warranties argued that since the leaseholder knew about the defects when it took the lease, its losses were self-inflicted

The consultant and contractors that had given warranties argued that since the leaseholder knew about the defects when it took the lease, its losses, which ran to millions of pounds, were self-inflicted. They resulted from the tenant’s own decision to proceed, not from the defendants’ defaults.

The defendants also pointed to the position under the lease. The landlord had no duty to repair the defects itself because the tenant had expressly accepted the premises in their actual condition at the start of the lease.

More importantly, the tenant had no such duty either, because of the limited wording of its repairing covenant. The repair costs had been incurred for the convenience of the tenant and not as a matter of legal obligation. Therefore recovery should not be permitted.

The judge dismissed both arguments. Although the original tenant was aware of the defects before entering the lease, it did not follow that the defendants’ defaults were not the dominant cause of the resulting losses. As for the position under the lease, it was irrelevant that the tenant did the repairs in the absence of an obligation under the repairing covenant. It only had to prove it had reasonably incurred costs owing to a breach of contract on the part of the warrantor.

But there was more. The defendants relied on the recent House of Lords case of Transfield, which had resulted in a subtle change to the law about recoverable damages for breach of contract. Damages are now to be limited to losses that the parties, on objective interpretation, intended to be recoverable. So unusual losses, or losses unquantifiable in advance, are unlikely to be claimable.

In the Transfield case the question was whether or not a charterer of a vessel was liable for the entire cost of a highly profitable subsequent charter that was lost to the vessel’s owner because of his late return of the ship. It was decided that his liability was limited to the lost profit attributable to the period of late delivery only, not the entire duration of the lost charterparty.

In the Widows case, the defendants argued, based on Transfield, that losses suffered by a beneficiary described as a funder in the warranty could not be recovered by that beneficiary when they had, in fact, sustained them in an alternative capacity as a tenant. Such losses fell outside the parties’ reasonable contemplation just as the higher charterparty costs did in Transfield. Again the judge ruled against this argument.

A number of lessons can be drawn from this case. First, the argument about damages can be pre-empted by suitable wording in the collateral warranty. This could describe, where appropriate, the alternative capacities in which a beneficiary may be acting. Where the position is unclear at the beginning of the project and an intended beneficiary might be either a funder, purchaser or tenant, that should be spelled out in the recitals and will put paid to the Transfield argument.

Second, the warranties for this project all contained a clause headed “continuing effect”, which stated that the provisions of the collateral warranty should continue to operate even if the employment of the warrantor was suspended or terminated during the project. There is no equivalent clause in the industry standard forms so if the contractor is able to terminate their employment, perhaps at a late stage in the life of the contract, a purchaser or tenant will get no protection at all from a warranty already entered into if defective work becomes apparent later on. A continuing effect clause could be very useful to a beneficiary in such circumstances.

Third, it should be possible to deal with the unmeritorious argument that where defects have arisen in a building before a party takes a lease, the “loss” has arisen before ownership and they have no claim. A clause in a collateral warranty which makes it clear that the beneficiary has a claim against the warrantor arising from a breach of the warrantor’s contract, whenever that breach occurred, including before the date of the beneficiary’s interest arose, would lay the matter to rest.

Tony Blackler is a partner in solicitor Macfarlanes