Collateral warranties get clarity at last

Animal Farm, George Orwell’s key notion was that “all animals are equal, but some are more equal than others”. This concept of exceptions to the orthodoxy is applicable to collateral warranties. I say this because it was largely well understood among construction lawyers who draft agreements for lease, building contracts and related derivative agreements such as bonds, parent company guarantees and collateral warranties, that the Construction Act does not apply to collateral warranties unless it actually requires the contractor to carry out construction operations on request by the beneficiary (typically a tenant or funder).

For example, it may be that in the latter scenario, the contractor is expressly under an obligation to return to the project to fix defects when requested by the beneficiary of the collateral warranty. The problem was that several cases had removed the exception and equated the standard wording in collateral warranties with “construction contract” as used in section 104(1) of the Construction Act.

The Supreme Court has now fixed the problem. In Abbey Healthcare (Mill Hill) Ltd (respondent) vs Augusta 2008 LLP (formerly Simply Construct (UK) LLP) (appellant) [2024] UKSC 23, the Supreme Court has overruled both earlier cases – Parkwood Leisure Ltd vs Laing O’Rourke Wales and West Ltd [2013] EWHC 2665 (TCC) and the Court of Appeal’s 2022 (majority) decision in Abbey Healthcare.

The Supreme Court has now helpfully clarified that:

• A collateral warranty will be an agreement “for… the carrying out of construction operations” if it is an agreement by which the contractor undertakes a contractual obligation to the beneficiary to carry out construction operations which is separate and distinct from the contractor’s obligation to do so under the building contract.
• A collateral warranty where the contractor is merely warranting its performance of obligations owed to the employer under the building contract will not be an agreement “for” the carrying out of construction operations.

The exception has been restored. The legal and building contract sectors will be happy with the Supreme Court’s decision and analysis. This is not to suggest that adjudication is bad, but it merely reflects the accurate point that adjudication should not be too readily implied or visited upon agreements that are more akin to financial guarantees or bonds.

The Supreme Court’s decision allows those who really want adjudication in collateral warranties to expressly contract into the Construction Act

As Lord Hamblen said, “a collateral warranty will not be an agreement ‘for’ the carrying out of construction operations for the purposes of section 104(1) if it merely promises to perform obligations owed to someone else under the building contract. There needs to be a separate or distinct obligation to carry out construction operations for the beneficiary; not one which is merely derivative and reflective of obligations owed under the building contract.”

The facts are not atypical: Put very simply, the contractor gave a collateral warranty to the tenant after practical completion; the tenant notified defects and requested to rectify them; Simply did not do so; the purchaser engaged a third party contractor to carry out remedial works; Abbey states it paid for the remedial works on behalf of the purchaser; both the purchaser and tenant issued adjudication proceedings; the adjudicator awarded the purchaser damages of around £1m, plus interest, in respect of the cost of the remedial works (and rejected its claims relating to an aborted sale to a prospective purchaser); and in the Abbey adjudication, the adjudicator awarded Abbey damages of £869,500 in respect of its loss of profit resulting from the defects, plus interest.

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Readers may wonder why this issue went all the way to the Supreme Court. In practical terms, given that the adjudication decisions are now unravelled, the purchaser and tenant may need to use litigation, but litigation may provide procedural and substantive benefits to the contractor – of course, one does not know the details, but the short point is that adjudication is not equivalent to litigation.

The Supreme Court’s analysis may have wider implications for construction lawyers. I say this because the court also clarified that the notion that the words in section 104(1) (“an agreement…for… the carrying out of construction operations”) is a broad expression for the purposes of statutory interpretation has been firmly squashed. The process of statutory construction must be approached in the normal way – asking what the statute says and what it is seeking to achieve by what it says.

Readers may have lived experience of how the “broad construction” of aspects of the Construction Act have played out, whether in adjudication or at the enforcement stage. One of the lord justices in the Court of Appeal had considered that a “broader construction” was also supported by the fact that a statutory purpose of the Construction Act was that where the same factual disputes arise under a building contract and a collateral warranty, they should both be referred to adjudication, thereby ensuring consistency of approach and outcome and a reduction in costs. The Supreme Court did not agree – the use of adjudication “does not assist in interpreting how it has drawn the boundaries of section 104(1)”.

The Supreme Court’s decision provides long-awaited and welcome clarity for the industry, adjudicators and courts. It may not have been a surprise to many in the industry. It allows those who really want adjudication in collateral warranties to expressly contract into the Construction Act. More fundamentally, the decision will force us to look precisely at what the Construction Act states rather than adopt a “broader view” perhaps based on our subjective thoughts on the benefits of adjudication.

Hamish Lal is a partner in Hamish Lal Partners