what is a collateral assignment of construction contract

Collateral Assignment: A General Guide

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A collateral assignment involves granting a security interest in the asset or property to a lender. It is a lawful arrangement where the borrower promises an asset or property to the lender to guarantee the debt repayment or meet a financial obligation. Moreover, in a collateral assignment, the borrower maintains asset ownership, the lender holds the security interest, and the lender has the right to seize and sell the asset in event of default. This blog post will discuss a collateral assignment, its purpose, essential considerations, and more.

Key Purposes of a Collateral Assignment

Collateral assignment concerns allocating a property's ownership privileges, or a specific interest, to a lender as loan collateral. The lender retains a security interest in the asset until the borrower entirely settles the loan. If the borrower defaults on loan settlement, the lender can seize and market the collateral to recover the unpaid debt. Below are the key purposes of a collateral assignment.

• Enhanced Lender Protection: The primary purpose of the collateral assignment is to provide lenders with an added layer of security and assurance. Also, by maintaining a claim on the borrower's properties, lenders lower their risk and improve the probability of loan settlement. In case of default, the lender can sell the collateral to recover the unpaid balance. This security authorizes lenders to offer loans with lower interest rates, as the threat associated with the loan is reduced.
• Favorable Loan Terms: Collateral assignment allows borrowers to access financing on more favorable terms than unsecured loans . However, the terms of the loan will vary depending on the borrower’s creditworthiness and the value of the collateral. Generally, lenders are more willing to extend larger loan amounts and lower interest rates when they have collateral to fall back on. The presence of collateral reassures lenders that they have a viable means of recouping their investment, even in case of default. This increased confidence often leads to more competitive loan offers for borrowers.
• Unlocking Asset Value: Collateral assignment enables borrowers to leverage the value of their assets, even if those assets are not readily convertible into cash. For instance, a business owner with valuable machinery can assign it as collateral to secure a business loan. This arrangement allows the borrower to continue utilizing the asset for operational purposes while accessing the necessary funds for expansion or working capital. Collateral assignment, thus, enables the efficient allocation of resources. However, the collateral will still be considered in determining the loan amount and terms.
• Access to Higher Loan Amounts: When borrowers promise collateral against a loan, lenders can present greater loan amounts than for other unsecured loans. The worth of the collateral serves as a reassurance to lenders that they can recover their investment even if the borrower fails to settle the loan. Therefore, borrowers can obtain higher loans to finance important endeavors such as purchasing property, starting a business, or funding major projects.
• Diversification of Collateral: Collateral assignment offers flexibility for borrowers by allowing them to diversify their collateral base. While real estate is commonly used as collateral, borrowers can utilize other valuable assets such as investment portfolios, life insurance policies, or valuable personal belongings. This diversification allows borrowers to access financing without limiting themselves to a single asset, thereby preserving their financial flexibility.

Steps to Execute a Collateral Assignment

A collateral assignment is a financial procedure that involves utilizing an asset as security for a loan or other responsibilities. Below are the essential steps involved in the collateral assignment process.

• Assess the Need for Collateral Assignment. The initial step in collateral assignment is determining whether collateral is necessary. Lenders or creditors may require collateral to mitigate the risk of default or ensure repayment. Evaluating the value and marketability of the proposed collateral is crucial to ascertain if it meets the lender's requirements.
• Select Appropriate Collateral. The next step involves choosing a suitable asset for collateral assignment. Common classifications of collateral comprise stocks, real estate, bonds, cash deposits, and other valuable assets. The collateral's value should be sufficient to cover the loan amount or the obligation being secured.
• Understand Lawful and Regulatory Requirements. Before proceeding with collateral assignment, it is essential to comprehend the lawful and regulatory provisions specific to the jurisdiction where the transaction happens. Collateral assignment laws can vary, so seeking advice from legal professionals experienced in this area is advisable to ensure compliance.
• Negotiate Provisions. Once the collateral is recognized, the collateral assignment provisions must be negotiated among the concerned parties. It includes specifying the loan amount, interest rates, repayment terms, and any further duties or limitations associated with the collateral assignment.
• Prepare the Collateral Assignment Agreement. The collateral assignment agreement is a lawful document that typically includes details about the collateral, the loan or obligation being secured, and the rights and responsibilities of both parties. It is highly advised to engage the services of a legal specialist to prepare or review the contract.
• Enforce the Collateral Assignment Agreement. After completing the collateral assignment agreement, it must be executed by all involved parties. This step ensures that all necessary signatures are obtained and copies of the agreement are distributed to each individual for record-keeping objectives.
• Notify Relevant Parties. To ensure proper recognition and recording of the collateral assignment, it is important to notify all relevant parties. It may involve informing the lender or creditor, the custodian or holder of the collateral, and any other pertinent stakeholders. Sufficient documentation and communication will help prevent potential disputes or misunderstandings.
• Record the Collateral Assignment. Depending on the nature of the collateral, it may be necessary to record the collateral assignment with the appropriate government authority or registry. This step provides public notice of the assignment and establishes priority rights in case of multiple claims on the same collateral. Seeking guidance from legal professionals or relevant authorities can determine if recording the collateral assignment is required.
• Monitor and Maintain the Collateral. Throughout the collateral assignment term, it is crucial to monitor and maintain the value and condition of the collateral. This includes ensuring insurance coverage, property maintenance, and compliance with any ongoing obligations associated with the collateral. Regular communication between all parties involved is essential to address concerns or issues promptly.
• Terminate the Collateral Assignment. Once the loan or obligation secured by the collateral is fully satisfied, the collateral assignment can be terminated. This involves releasing the collateral from the assignment, updating relevant records, and notifying all parties involved. It is important to follow proper procedures to ensure the appropriate handling of the legal and financial aspects of the termination.

Key Terms for Collateral Assignments

• Security Interest: It is the legal right granted to a lender over the assigned collateral to protect their interests in case of borrower default.
• Collateral Valuation: The process of determining the worth or market value of the assigned collateral to assess its adequacy in securing the loan.
• Release of Collateral: The action taken by a lender to relinquish its claim over the assigned collateral after the borrower has fulfilled the loan obligations.
• Subordination Agreement : A legal document that establishes the priority of multiple creditors' claims over the same collateral, typically in the case of refinancing or additional loans.
• Lien : A legal claim or encumbrance on a property or asset, typically created through a collateral assignment, that allows a lender to seize and sell the collateral to recover the loan amount.

Final Thoughts on Collateral Assignments

A collateral assignment is a valuable instrument for borrowers and lenders in securing loans or obligations. It offers borrowers access to profitable terms and more extensive loan amounts while reducing the risk for lenders. Nevertheless, it is essential for borrowers to thoughtfully assess the terms and threats associated with collateral assignment before proceeding. Seeking professional guidance and understanding the contract can help ensure a successful and beneficial financial arrangement for all parties involved.

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The Contractor’s Consent – A Trap for the Unwary

On private construction projects, the lender often requires that the owner/borrower obtain the written consent of the contractor to the collateral assignment of the construction contract by the owner to the lender. This permits the lender to step into the owner’s shoes with respect to the construction contract in the event of the owner’s default under the project loan documents. Unfortunately, the Consent forms developed by most lenders these days have many more serious implications for contractors.

Although the general form of the Consent is similar among lenders, the forms are becoming increasingly customized and include many terms other than just the consent to assignment. Whenever faced with such a document, a contractor must be alert and should watch for the following:

Notice of Default/Termination The Consent may require that the contractor provide written notice to the lender if there has been any default by the owner under the construction contract or if the contractor wishes to terminate the construction contract. If the contractor forgets (in the heat of the battle) to provide notice to the lender, it may render the declaration of default or termination ineffective. Failure to provide notice would also certainly impair any rights the contractor may wish to assert against the lender.

Change Order Approval Most lenders’ Consent forms require the contractor to obtain prior written approval of the lender to any change orders between the contractor and the owner. Given the lender’s responsiveness, at the very least this is an administrative annoyance, but at its worst, this is a detail that could impact the Project schedule or disrupt the contractor’s negotiations with the owner. Contractors should seek to eliminate this requirement in its entirety, but failing that, should limit its applicability to only change orders over a stated dollar amount.

Assignment Once a lender takes over a project from a defaulting owner, it may seek to assign the lender’s rights in the construction contract to a new entity. It will want to make that assignment without the contractor’s consent and will typically include a provision in the Consent form allowing it to do so. Contractors should be wary of these clauses and insist that no assignment can be made without the contractor’s prior written consent.

Mechanics’ Lien Rights Most lenders include in their Consent forms a provision in which the contractor either waives its mechanics’ lien rights on the Project or subordinates its mechanics’ lien rights to the lender’s mortgage rights. In Minnesota, we have a statute (Minn. Stat. § 337.10, Subd. 2) that may make a prepayment lien waiver unenforceable, but it is not settled whether it makes a lien subordination unenforceable. Although such subordination clauses seem unfair, especially considering that the lender likely has a title insurer insuring its priority, lenders will resist the well-advised efforts by contractors to remove the subordination provision.

Payment Upon Takeover One of the primary purposes of the Contractor’s Consent is to ensure that, if there is a default and the lender must take over an uncompleted Project, the contractor will complete the Project for the lender according to the terms of the construction contract. The typical form logically requires the lender to pay the contractor going forward from the time of lender takeover. Most forms, however, do not obligate the lender to pay the contractor any amounts unpaid at the time of takeover. This should not be acceptable to any contractor – especially one that has been required to subordinate its mechanics’ lien rights to the lender’s mortgage.

Lenders have lately been more sensitive to contractors’ concerns and have been willing to agree to cure pre-takeover defaults (including payment defaults) in addition to paying post-takeover costs. This is certainly something to be negotiated by the contractor at the time it is being asked to sign a consent form.

Conclusion Do not take the Contractor’s Consent lightly. Rarely should you accept the standard form you receive from the lender. Make it fair and protect your rights.

Collateral Contracts: Everything You Need to Know

Collateral contracts are independent oral that are made between two parties to a separate agreement or between one of the original parties and a third party. 5 min read updated on July 26, 2024

Updated April 26, 2022:

Collateral contracts are independent oral or written contracts that are made between two parties to a separate agreement or between one of the original parties and a third party. This type of contract is usually made before or simultaneously with the original contract. A collateral contract is a secondary agreement added to the original contract that is meant to ensure that the pre-contract promises are met.

What Is a Collateral Contract?

In most cases, collateral contracts are written as  unilateral contracts . With this contract, one party promises something to another party. When an offer is made and accepted, this agreement is the original purpose of the contract. The consideration involved in a collateral contract is essentially a guarantee that both parties will enter and uphold the original contract. Three-way agreements are often used to avoid this issue.

Collateral contracts are secondary agreements that are related to the first agreement. For example, when a contract is used for the exchange of goods, the collateral contract can be used to make sure those goods are of the quality promised before the contract was entered.

Legally  enforceable contracts  must adhere to four important  principles :

• One party offers something to another party.
• The offer has been accepted.
• Each party will benefit in some way from the relationship.
• The intent of the offer is to create a legal relationship.

Reasons to Create a Collateral Contract

Collateral contracts are most often made because:

• They contain terms that conflict with the terms of the primary agreement.
• The incorporation of these terms in the main contract is superseded by rules of evidence.
• The main contract has been written incorrectly.
• A third-party mediator is needed to resolve an issue between the original parties.
• The parties do not want or cannot overstep the primary contract's privity.

Most collateral contracts are unilateral, which means that only one party makes a promise (such as providing a product or service) in exchange for funds. The agreement to the original contract serves as consideration for the collateral contract.  With the collateral contract, terms of the original contract can be replaced if certain conditions are met . For instance, if you hire someone to complete a construction project and the person you've hired then  purchases the project materials from a third party, you may be able to sue the third party if their materials are defective or of low-quality.

Collateral warranty applies when a collateral contract involves more than three parties. In these situations, each party must be sure to meet their responsibilities to the other parties.

How Collateral Contracts Work

The main and collateral contracts are active at the same time, and in some cases, the provisions of the latter may override those of the former. For example, companies X and Y enter a construction contract with X as the client and Y as the builder. Y then enters a collateral contract with Z, a materials supplier. If the materials are found defective, X may be able to sue Z even though they do not have a contract with one another.

Sometimes called a collateral warranty, this arrangement obligates all contracting parties to meet their accountability to all other associated parties. A collateral contract must:

• Be consistent with the main contract
• Be promissory
• Follow the promise with a statement
• Contain all elements of a contract

Are Collateral Contracts Enforceable?

A second consideration should be used with a collateral contract to make sure that it is viable on its own. In commercial transactions, it's very common for parties to use side deals. In many cases, these deals are informal and can be used to bolster the original contract. Side deals can either be agreed to verbally or in a written document such as a letter.

Generally, the parties will have good reasons for not formalizing the side deal. However, both parties usually want to make sure that this side deal can be enforced. In the  Adicho v. Dankeith  court case, it was found that a side deal between the two parties could not be enforced because the terms of the side deal conflicted with those of the main contract.

When using side arrangements, it's important to make sure they are fully documented and follow the rules for forming contracts. Otherwise, it's likely the side deal will not be legally enforceable.

Collateral Contract Examples

Example #1 - Consider De Lassalle v. Guildford, a collateral contract case in which the latter party rented a home to the former. The landlord promised to fix the drain before the tenant moved in. This promise was considered a collateral contract by the court, allowing the tenant to sue when he found the drains had not been fixed as promised.

Example #2 -  A good example this type of contract is the Shanklin Pier v. Detel judgment. This case involved a group of people who owned a pier and purchased paint for their pier with the promise that the paint would last for seven years (a guarantee that was made specifically to entice the pier owners to purchase this paint). Based on the promise of durability, the pier owners purchased the paint and then used it on their pier. Unfortunately, the paint lasted for a three-month period, considerably less than the time span that was promised. Although the contract in place was for the purchase of the paint, it was ruled that the pier owners were able to pursue damages based on a collateral contract.

Bipartite and Tripartite Collateral Contracts

With a bipartite collateral contract, both parties who enter the main contract also enter the collateral contract. A tripartite collateral contract includes a promissory statement by a third party who is not involved in the original contract. This is often used in the case of a purchase agreement , for example.

The Parole Evidence Rule

This rule prevents parties from changing the meaning of written contracts with oral or implied agreements that are not included in the original contract, thus damaging its integrity. This means that if a contract is in writing, later agreements that are not made in writing will not be taken into evidence in a contract dispute. However, several exceptions exist to this rule.

• When evidence of custom exists, oral agreements may be honored. This means that the changes in question are part of custom and do not need to be explicitly included.
• If the operation of the contract has expired, the parties will not be bound by the contract. For example, if a person enters into a contract to buy a used car on the agreement that the tires will be replaced and the seller fails to do so, the contract is void.
• If the written agreement does not represent the entire contract, the parole evidence rule does not apply.
• If the oral agreement clarifies unclear language, it will be taken into evidence.
• If the update to the contract corrects errors in the original contract.
• Oral evidence will be accepted if it is needed to recognize the parties to the contract.

Parole evidence rules do not apply to collateral contracts, only to primary contracts.

Consideration and Estoppel

Consideration is a contract requirement under common law and means that each party must bring something of value to the table. If a party wants to legally enforce a contract, it must show that it provided a benefit or suffered damages. While money can sometimes serve as a consideration, this is not always sufficient. Consideration does not necessarily need to constitute a fair and legal exchange but must be judged as adequate by the court.

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Pitfalls of Contractor’s Consents

by Michael Lilly

October 23, 2020

You’ve negotiated your Agreement with the Owner and you’ve started to mobilize.  The Owner is still trying to close on its construction financing – but they are “close.”  You receive a call from the Owner’s representative, the representative says “closing is scheduled for tomorrow, the lender just needs you to sign a document before they will fund, it’s no big deal, I’ll send it over to you right now – just sign it and get it to me as soon as possible.”  Finally!  The project is about to start!  You receive the document, a Contractor’s Consent, and you are inclined to just sign it and get to work. Should you?

What Is It Really?

In virtually every construction loan transaction with a commercial lender, the lender will require the borrower (owner) to assign the borrower’s interest in its construction contract with the general contractor, to the lender as additional collateral. This document is generally referred to simply as an Assignment of Construction Contract or Collateral Assignment of Construction Contract.  In connection with the borrower’s delivery of the Assignment of the Construction Contract, the lender will generally require that the borrower’s general contractor consent in writing to such assignment.  Thus, a Contractor’s Consent is first and foremost the general contractor’s written consent to the borrower’s collateral assignment of the construction contract.  However, lenders will ordinarily include multiple additional terms and concepts that the contractor should consider.

THE MAJOR ISSUES

If the Lender elects to assume the Construction Contract, when will it happen?

In the event of a borrower default under the loan documents, nearly every Contractor’s Consent sets forth a procedure allowing for the lender to either (i) terminate the project, or (ii) to assume the construction contract and take-over the project. Often, however, the consent will not require that the lender makes its choice, to either terminate or assume the construction contract, within a specific period of time.  Thus, should the lender declare the borrower in default, what is the general contractor to do?  The short answer is – the general contractor must stop work and wait on the lender to make a decision.  This will, in the very least, result in additional de-mobilization costs and potentially significant re-mobilization costs (should the lender elect to proceed with the contract).

What can the general contractor do?  Negotiate a specific time frame for the lender to make its election to terminate or assume the construction contract.

Lender consent to Change Orders.

Often Contractor’s Consents will include a specific obligation that the borrower and contractor obtain the Lender’s prior consent to any Change Orders.  The result – an already time consuming and often difficult change order process become infinitely more time consuming and difficult, as lenders are typically reluctant to agree to changes in cost and scope for a project.

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Collateral warranties in construction contracts - the basics

A collateral warranty is a contract under which a party involved in the works warrants to a third party beneficiary that it has fulfilled its obligations under its underlying building contract, subcontract or professional appointment (referred to as underlying contract in this article).

In this article we explore the purpose and typical content of a collateral warranty in the context of a construction project. We also briefly consider an alternative approach as provided by the Contracts (Rights of Third Parties) Act 1999.

In a simple construction project, an employer may contract with a contractor to carry out building works. Those two parties usually have a clear contractual relationship.

However, construction projects invariably involve a wide range of parties with an interest in the development (funders, purchasers, tenants for example) and also those involved in the works (contractors and consultants). Some of those parties will not have a direct contractual link or a commercial relationship of any sort.

Ordinarily, only a party to a contract is entitled to enforce said contract. Therefore, if a subcontractor were to commit a breach of its subcontract (with the contractor), and that breach adversely impacted on the employer (this could also be a funder/purchaser or tenant), an employer would be unable to enforce the same. That creates a problem for the employer particularly in a situation where the main contractor is insolvent.

In addition, if the employer identify defects in the subcontract works, in the absence of a collateral warranty the employer would have no realistic contractual recourse against any party in the example above.

In the absence of that contractual link, the employer would have to rely on a claim in negligence. This is not desirable as it would require the employer to establish that the subcontractor owed it a duty of care before its claim was even considered. Even if successful, the employer would also be limited as to what it could recover in negligence.

Collateral warranties are used to bridge the contractual gap and create a direct contractual link for the benefit of those parties that may otherwise have no recourse.

The step-in option

Some collateral warranties can also contain ‘step-in’ rights which effectively allow the beneficiary to step in to the underlying contract and issue instructions.

Should the main contractor of a project fall into insolvency the subcontractor will be under no contractual obligation to accept instructions from the employer to complete the works given there exists no contractual relationship. The use of a collateral warranty in this instance creates a direct contractual link allowing the employer to give instructions to the subcontractor, ensuring completion of the latter’s obligations is achieved.

Key contractual considerations

Effectively a collateral warranty is a shortened version of the underlying contract and so should reflect the obligations therein. We would expect to see direct provisions as to:

• Principal covenant – The warrantor warrants to the beneficiary that it has and will fulfil its obligations under the underlying contract and perform its obligations with an appropriate level of skill and care.
• Insurance - The level/basis of insurance the warrantor is obliged to maintain for the duration of the warrantor’s liability period.
• Step-in rights - Gives the beneficiary the ability to step-in to the underlying contract in place of the instructing party in certain circumstances.
• Intellectual property licence – A right for the beneficiary to reproduce and use the warrantor’s intellectual property.
• Assignment - The ability to ‘pass on’ the benefit of the warranty to an alternative third party beneficiary.
• Materials – That materials used or specified by the warranting party will be or were fit for use and not deleterious in nature.

Are parties required to provide collateral warranties?

This is dependent on the terms of the underlying contract. Providing a collateral warranty increases the potential scope of a provider’s liability, so careful thought should be given to the decision to do so.

If so required, a party may seek to limit the number of warranties it is obliged to provide, or limit the scope of the same by proposing an overall cap on its liability.

A warranting party (and its insurers) is unlikely to want to extend its obligations in a collateral warranty beyond those contained in its underlying contract. Such clauses are standard in the collateral warranties we see.

If entering into a collateral warranty, it is important to seek legal advice to ensure that the terms are acceptable for the required purpose, whether from the perspective of a beneficiary or the warranting party.

Third-party rights - An alternative approach?

A statutory exception to the doctrine of privity of contract was introduced by the Contracts (Rights of Third Parties) Act 1999 (the Act).

The Act allows a third party to enforce the terms of a contract where an express right has been granted or the contract confers a benefit on the third party. The contract should clearly identify any third party beneficiary by name or particular category (eg purchasers or tenants), with such beneficiaries typically set out in a rights schedule annexed to the underlying contract. Any such beneficiary will benefit from any remedy that would be available in an action for breach of contract as if they were a party to said contract.

Granting rights under the Act, particularly to members of a class, may result in the construction of a wide range of third party beneficiaries, which may place undue risk on the warrantor. While such rights are sometimes granted, contractors and consultants typically prefer to exclude them entirely by an express term of the contract, instead relying on collateral warranties.

Collateral warranties will continue to act as useful security in construction projects, allowing a beneficiary to avoid the issues associated with bringing a claim in negligence if issues arise.

Both collateral warranties and third-party rights can extend the scope of a warranting party’s liability beyond its direct employer, which may be beyond what was perhaps initially anticipated. While construction professionals generally accept that collateral warranties, or third-party rights, form part of a typical construction suite of contracts, the scope of additional liabilities to third-party beneficiaries should be factored in to the agreed price when negotiating an underlying contract.

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Collateral Assignment of Acquisition Agreements | Practical Law

Collateral Assignment of Acquisition Agreements

Practical law standard document w-006-7145  (approx. 24 pages).

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Assignment, novation and construction contracts - What is your objective?

Consider a not too hypothetical situation where the parties to a construction project (employer, contractor and sub-contractor) enter into a Deed of Assignment intending that the employer, having lost confidence in the contractor, would directly engage the sub-contractor to complete the sub-contract works. But what if no assignment has taken place? What are the terms of the contract under which the sub-contractor carries out the works for the employer?

Potential risks with assignment

In construction projects, main contractors often assign the benefit of their key sub-contracts to the employer in the event of contractor default and consequent termination of the main contract. The employer can then enforce the rights in the sub-contract against the sub-contractor, including rectification of the works and the performance of particular obligations.

However, there are potential risks associated with assignment in these situations as the Technology and Construction Court’s decision in Energy Works (Hull) Ltd v MW High Tech Projects UK Ltd demonstrated. We discussed this decision in Assigning a sub-contract on termination: which rights is the contractor giving up? In this case, the nature of the assignment meant that the main contractor could not pursue claims made by the employer against its sub-contractor under the sub-contract. This limited the main contractor’s ability to ‘pass on’ any liability it had under the main contract to the sub-contractor.

But what if the Deed of Assignment does not take effect as an assignment?

Assignment v novation

Both assignment and novation are forms of transferring an interest under a contract from one party to another. However, they are very different and in their effect. An assignment transfers the benefit of a contract from one party to another, but only the benefit, not the burden. In contrast, a novation will transfer both the benefit and the burden of a contract from one party to another. A novation creates a new contractual relationship - a ‘new’ contract is entered into.

Another key difference with novation is that the consent of all parties concerned must be obtained, which is why novation is almost always effected through a tripartite agreement. In the case of an assignment, it is not always necessary to obtain consent, subject to what the specific terms of the contract provide.

When deciding whether to assign or novate, parties should consider (i) whether there is in fact a burden to novate, (ii) whether the novatee will be willing to take on the burden, (iii) whether all parties will consent to the novation and indeed enter into the agreement. If there is no burden under the contract to transfer, then an assignment is likely to be the most appropriate way to transfer the interests.

Is the Deed for an assignment or a novation?

Although a document may be labelled a Deed of Assignment, if it has references to the transfer of ‘ responsibilities and obligations ’ and is a tripartite agreement these are characteristic of a novation as opposed to an assignment.

A key issue in such circumstances is to ascertain whether making use of the words ‘ assigning ’ and ‘ assignment ’ actually affects the characteristics of the document.

There has been some consideration of this characterisation issue by the courts. In the case of Burdana v Leeds Teaching Hospitals NHS Trust [2017] EWCA Civ 1980, by majority the Court of Appeal decided that on the facts of the case, although the Deed of Assignment in question referred to an ‘ assignment ’ of the benefit and burden, on proper analysis there was indeed a novation.

Furthermore, in the case of Langston Group Corporation v Cardiff City FC [2008] EWHC 535, Briggs J made it evident that even though the variation agreement in question did not use the word ‘ novation ’ and did not describe itself as such, the circumstances and effect of the agreement was indeed a novation and a new contract had been created.

It may be the case that even if a document does not describe itself as a novation, yet has the key characteristics of one, then as a matter of interpretation the courts would accept that the document takes effect as a novation.

Key characteristics of a novation

If entering into a document that purports to be a Deed of Assignment, tread carefully as it may well take effect as a novation, particularly if the following characteristics are present:

• It is a tripartite agreement;
• All the parties give their consent;
• The novator has been released from its obligations;
• There has been an acceptance of the terms of the novation on the part of the novatee and the substituted party; and
• There is a vesting of remedies.

What is your objective?

Although a document may well be labelled as an assignment, it may have the characteristics of and take effect as novation. Parties need to be cautious and consider what they want to achieve when assessing whether to assign rights or to novate them along with obligations.

This article was written by Anna Sowerby and Eveline Strecker. For more information, please contact Anna  or your usual Charles Russell Speechlys contact.

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How to Balance Lender and Contractor Interests on Alternative Energy Construction Projects

Lenders who finance wind and solar farms often require the EPC contractor to consent to the developer’s assignment of the EPC Contract to the lender to secure the developer’s obligations under the loan documents. Such consents are typically included in a “Consent and Assignment” or “Consent and Agreement” that also includes other promises and representations by the contractor. Because lenders usually depend on the value of the project as collateral for the loan, if the project is not completed, the value of that collateral is severely limited. The Consent and Assignment ensures that the lender can step in for the developer to have the contractor complete the project if the developer defaults on its loan obligations. Contractors, on the other hand, want to ensure that they get paid for the labor, materials and equipment provided to the project. Careful drafting of a Consent and Assignment can protect both lenders and contractors.

Consent to Assignment

The first substantive section in most Consent and Assignments is the contractor’s express consent to the collateral assignment of the EPC Contract to the lender. It requires the contractor to acknowledge that the lender has the right to take over the developer’s role in the EPC Contract, exercising the developer’s rights as the “Owner” under the EPC Contract. This provision gives the lender the assurance that it will be able to have the contractor complete the project even if the developer defaults.

Contractors want to make sure they get paid for their work. Lenders will often agree to pay only for the work of the contractor after the lender steps in, but not for work performed before the takeover. However, the contractor will have difficulty paying its subcontractors and suppliers if the contractor does not receive payment for the previous work. If they are not paid, subcontractors and suppliers may walk off the project or become uncooperative. Then the contractor could have difficulty completing the project, subjecting the contractor to potential liability under the Consent and Assignment. Thus, contractors will want language requiring the lender to cure all payment defaults by the developer under the EPC Contract before the contractor agrees to complete performance. 

Beyond payment, a contractor might depend upon numerous other contractual promises by the developer, such as:

• Access to the site
• Developer permits
• Developer furnished equipment
• Indemnity protection for claims caused by the developer
• Additional compensation for differing site conditions
• Protection from hazardous materials discovered on site
• Information about the project and the site
• Property insurance protection

It may be impossible or much more costly for a contractor to complete the work if such developer duties are not being performed. As a result, it is important for contractors to have language requiring the lender to cure all defaults by the developer under the EPC Contract and to perform all duties of the developer in the event the contractor continues performance for the lender. 

Continued Performance by Contractor

If a lender elects to take over the developer’s role in an EPC Contract, the lender usually wants to make sure that the contractor will continue performance so that the project can be completed as expeditiously as possible. If the contractor terminates before the lender is able to cure a developer default, completion of the project could be delayed significantly, if it is completed at all. Accordingly, most Consent and Assignments require the contractor to give the lender notice of a developer default and to provide the lender a cure period before the contractor is entitled to terminate the EPC Contract.

On the other hand, because the extended cure period can be as long as three to six  months, the contractor could lose millions of dollars while continuing to perform for several months if the lender ultimately decides not to take over the EPC Contract and cure any payment default. To protect themselves from such large potential losses, contractors often negotiate a provision allowing them to suspend performance after a reasonable period if the lender has not yet elected to pay the contractor for continued performance. The contractor may also negotiate the payment of extra costs resulting from such a suspension, as well as an extension in the construction schedule, should the lender take over after the contractor suspends performance.

A contractor will also have potential ongoing costs of standing by, even if the contractor has suspended performance. For example, there may be continuing equipment rental costs or stand-by costs for subcontractors or suppliers. The contractor may also need to keep employees committed to the project in case the lender accepts the assignment. As a result, a contractor may ask the lender to commit to pay the contractor compensation for extending the cure period, even where the contractor is allowed to stop work.

Change Order Approval and Notice of Claims

Lenders do not want to be surprised by material modifications to the EPC Contract. For that reason, some Consents and Assignments provide that all change orders (or change orders over a certain dollar amount) must be approved by the lender to be effective. This can make the change order process more cumbersome. More importantly, if the requirement for lender approval of change orders is not incorporated into the EPC Contract, the requirement could conflict with provisions in the EPC Contract that require the contractor to comply with change order directives from the developer. A contractor may want to provide in the Consent and Assignment that the contractor is not obligated to perform any change order for which there is no lender consent. In addition, there are usually provisions in an EPC Contract entitling a contractor to change orders under proper circumstances, such as force majeure, differing site conditions or changes in law. Because these are not optional change orders, a contractor should clarify in the Consent and Assignment that lender consent is not required for such change orders.

Some Consent and Assignments may require the contractor to provide notice of any “request or demand” to the developer. Such vague language can be difficult for a contractor to comply with, essentially requiring the contractor’s project personnel to copy the lender on all communications with the developer. Contractors may want to limit the types of written notice they are required to provide to lenders.

Representations by Contractor

Almost all lender-required Consent and Assignments also contain a series of representations and warranties by the contractor to give the lender additional comfort that the EPC Contract and Consent and Assignment are valid and binding and that the contractor is capable of performing its obligations under both agreements. Typical required representations include:

• The contractor is duly organized under applicable law and authorized to do business in the place where the project is located.
• All necessary corporate action has been taken by the contractor to enable the contractor to enter into the EPC Contract as well as the Consent and Assignment.
• The EPC Contract and the Consent and Assignment have been properly executed by appropriate officers of the contractor and are in full force and effect.
• There is no pending litigation that could adversely affect the contractor’s performance under, or the enforceability of, the EPC Contract.
• The execution and performance of the EPC Contract and the Consent and Assignment will not violate any applicable law or contractor’s corporate policies.
• The contractor is not aware of any current default under the EPC Contract.

A contractor required to make such representations should perform due diligence to confirm they are completely accurate and should request modifications to representations that are overly broad or speculative. For example, if a contractor is asked to provide a representation regarding the actions of the developer, or regarding possible present or future conditions that could impact the enforceability of the EPC Contract, the contractor may want to limit the representation “to the best of the contractor’s knowledge.”

Parties to Consent and Assignment

Many Consents and Assignments are set up to be signed only by the contractor or only the contractor and developer. However, if a contractor wants to include provisions in the Consent and Assignment as discussed above that are binding on the developer and lender, it is essential that the Consent and Assignment include the lender and developer as parties and be signed by them.

Contractors understand that lender financing is necessary for most solar and wind farm projects, and that such financing cannot happen without adequate safeguards to protect lenders’ interests. For that reason, most contractors will not object to signing a Consent and Assignment, but they may request reasonable modifications to protect their rights under the EPC Contract.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

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Out-Law Guide 5 min. read

Collateral warranties

01 Sep 2012, 3:51 pm

This guide provides a basic outline of the main issues to consider in relation to collateral warranties, and should be read in conjunction with our guide to  Professional appointments

Why are collateral warranties necessary?

Only the parties to a contract can generally sue to enforce the rights and obligations under it. This means that parties do not have to worry about unexpected claims from third parties. However, it can mean that where a third party has an interest in a construction project – for example, a funder or a tenant – then that third party may not be able to bring a contractual claim against the person who is at fault, as he has no rights under the relevant contract.

(Please also see "The Contracts (Rights of Third Parties) Act 1999" below.)

What does a collateral warranty do?

This is where the collateral warranty comes in. A collateral warranty is an additional contract between, commonly, a (1) contractor, consultant or subcontractor (warrantor) and (2) an interested third party (beneficiary) giving that third party the right to sue the warrantor. It is a useful contractual bridge which creates a direct contractual link which may not otherwise exist. This helps to provide an additional level of security for other stakeholders in a construction project who are not directly appointing the parties delivering it.

Collateral warranties are given in PPP projects for example by the professional team (for more detail please see Professional appointments  in favour of the procuring authority, funders and special purpose vehicle. For more detail on PPP projects please see Public Private Partnerships . They are also given by key sub-contractors.

It is important that a collateral warranty is consistent with the underlying contract it relates to.

What does a collateral warranty contain?

• Principal covenant: that the warrantor will fulfil its obligations under the underlying contract and, without prejudice to that covenant, that it will carry out any design with reasonable skill and care;
• copyright and use of information: third parties acquiring interests in construction projects will require the right to use the design information generated by the project. It's common to include clauses to allow for that right which often restrict the use of design documents to purposes connected with the relevant project;
• assignment: without restrictions, the benefit of a warranty can be assigned in the same way as any contractual benefit. Warrantors sometimes request limits on the number of permitted assignments of collateral warranties to seek to limit the number of third parties they may become liable to; For more detail on assignment and novation in construction contracts please see Assignment and novation :
• step-in rights: these are a common feature of warranties and are often given to beneficiaries who have an interest in the project before it is completed (eg they have provided funding). They give the beneficiary the right to take the place of the employer under the underlying contract, to ensure that it and the project continue, where the employer gets into difficulties that threaten the project. The beneficiary will take responsibility for any past and future unpaid sums under the contract. Step-in provisions often try to postpone the exercise of the warrantor's rights to terminate the underlying contract. This is to give funders time to react to the relevant issue and to make sure that they can exercise the step-in rights. If two or more parties have step-in rights under different collateral warranties (for instance funders and procuring authorities in PPP projects), there should be agreement on whose rights will take priority on step in;
• no greater liability clause: the warrantor seeks to ensure that it takes on no greater risk as a result of giving a collateral warranty than it has under the primary contract;
• equivalent rights of defence clause: the warrantor seeks to ensure that it has all the same rights of defence against claims under the collateral warranty as it does under the underlying contract;
• economic and consequential loss: These types of exclusions are resisted by beneficiaries, and their appropriateness will depend on the project-specific issues;
• if two warrantors are each liable to a beneficiary for the same defective work, the beneficiary could seek to recover 100% of its damages from warrantor 1, despite the joint liability of warrantor 1 and warrantor 2 in relation to the relevant defects. Warrantor 1 could then seek to recover a share of those damages from Warrantor 2 through the Civil Liability (Contribution) Act 1978 ;
•   a net contribution clause can take various forms. However, it will often state that where two or more warrantors involved in a construction project 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 problem). This means that a beneficiary has to pursue each warrantor who may have contributed to the defect. Effectively this transfers the burden of pursuing the other defaulting parties for their contribution from the warrantor to the beneficiary and can be problematic if the one of those defaulting parties is insolvent. This is why net contribution clauses are often resisted by beneficiaries.

The Contracts (Rights of Third Parties) Act 1999

The Contracts (Rights of Third Parties) Act 1999  was primarily aimed at the construction industry, to do away with the need for collateral warranties on each construction project. In broad terms, the Act provides that a person who is not a party to the contract may enforce a term of the contract if:

• the contract expressly provides that he may; or
• the contract term purports to confer a benefit on him.

The Act has not had as big an impact as originally thought, and is often expressly excluded in contracts. The fear was largely driven by the insurance industry, that the Act might inadvertently give rise to additional liability on contracting parties and increased claims against them by third parties. There is still little case law on the operation of third party rights and collateral warranties remain the most common mechanism to give third parties contractual rights of recovery in relation to construction projects.

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What is Assignment in Construction Contracts?

A legal assignment is transferring an interest from one party, called the assignor, to another, the assignee. An assignment entitles the assignee to the performance of a particular contractual obligation conferring a benefit. It’s not usually possible to assign burdens, obligations or debts under a construction contract .

An example of the assignment of a benefit in a construction contract is transferring a collateral warranty to the tenant or purchaser of a building either during construction or after completion. 

An employer can assign their right to have the building constructed and the subsequent right to sue the contractor if the works are not up to standard or delayed. Sometimes, financial investors want the developer to assign contractual rights as security for their investment.

To be legally valid, an assignment must satisfy the requirements of Section 136 of the Law of Property Act 1925. An assignment that doesn’t comply can still be effective as an equitable assignment, but it is harder to prove.

• Parties to construction contracts can only assign benefits and not obligations

• An assignment should comply with the provisions of Section 136 of the Law of Property Act 1925

• A construction contract may contain restrictions on the right to assign, so only permitting the assignment of certain rights or a limit on the number of assignments

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Collateral warranties – an update

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Last year, there were two key decisions relating to collateral warranties in Abbey Healthcare (Mill Hill) Ltd-v- Simply Construct (UK) LLP [2022] EWCA Civ 823 and Orchard Plaza Management Co Ltd -v- Balfour Beatty Regional Construction Ltd [2022] EWHC 1490 (TCC). 

In December 2022 it was confirmed that Simply has been granted permission to appeal to the Supreme Court in the case of Abbey Healthcare.

A collateral warranty is a promise by the contractor or a professional consultant (the warrantor) to carry out its obligations under a building contract or professional appointment for the benefit of a third party who has an interest in the construction project such as a purchaser, funder or tenant. 

These two cases cover (i) if a collateral warranty is a ‘construction contract’ under the Housing Grants, Construction and Regeneration Act 1996 (‘the Construction Act’) and (ii) the effect of assignment on the rights under a collateral warranty. 

Is a collateral warranty a construction contract? 

The question of whether a collateral warranty is a construction contract was previously considered in the case of Parkwood Leisure Ltd -v- Laing O’Rourke Wales and West Ltd [2013] EWHC 2665. This question is important because if a collateral warranty is found to be a construction contract, then the beneficiary has certain rights under the Construction Act including the right to adjudicate. The statutory process of adjudication is often a quicker and cheaper way to resolve disputes than litigation or arbitration. 

The decision in Parkwood was clear that not every collateral warranty would be a construction contract as it depended on the precise wording used; if a contractor warranted to positively carry out the construction operations, the collateral warranty would likely be a construction contract but if they only warranted to a previous state of affairs then it pointed towards the collateral warranty not being a construction contract. 

The case of Abbey Healthcare is an example of a beneficiary under a collateral warranty seeking to enforce its rights through adjudication. Abbey was the ultimate tenant and manager of a care home designed and built by Simply. There were some cladding and fire safety defects identified in the building which required remediation. The owner and Abbey commenced separate and successful adjudication proceedings against Simply for the cost of the remediation works. Simply did not pay and argued that the collateral warranty was not a construction contract and so the adjudicator had no jurisdiction. The judge at the enforcement hearing agreed that the collateral warranty was not a construction contract and seemed to rely on the fact that the warranty was given four years after practical completion so Simply were warranting to a past state of affairs and not providing a contract for the carrying out of construction operations. 

The decision of the judge was appealed and the Court of Appeal took a different view. Upholding Parkwood, the majority decided that whether a collateral warranty was a construction contract depended on its wording: whilst the wording in the Abbey collateral warranty differed from the Parkwood collateral warranty it still related to both past and future performance so was a construction contract. The Court of Appeal found that if a collateral warranty was akin to a performance guarantee, then the collateral warranty was not a construction contract. 

The position established by the Court of Appeal could be overturned by the Supreme Court. It remains to be seen if the Supreme Court will row back from the position in Abbey to the earlier more limited position in Parkwood. Until the Supreme Court reaches its decision, any beneficiary under a collateral warranty looking to commence dispute resolution procedure ought to be cautious about pursuing adjudication proceedings. 

Assignment of a Collateral Warranty 

The facts of Orchard Plaza are that a warranty originally given in favour of the funder was then assigned twice, as permitted by the terms of the collateral warranty, to the developer and then finally to the building owner. 

Warranties usually provide a right to assign, albeit usually such assignments are limited in number or limited to a category of beneficiary. It is common to also see what is called a ‘no loss’ clause. This clause is intended to prevent the warrantor arguing that an assignee cannot recover an amount under the collateral warranty because it is an assignee and the assignor has not suffered or incurred any loss or would not have suffered that type of loss. 

In Orchard Plaza, the building owner sought to recover the cost of remedial works from the contractor under the collateral warranty.

The contractor argued that the loss was too remote (ie not reasonably foreseeable as at the date of the underlying contract) as the losses that could have been foreseen by the contractor were those suffered by the funder who originally had the benefit of the collateral warranty (ie the diminution in value of its security). 

The court held that the losses suffered by the building owner were not too remote. It clarified the test for remoteness was whether the kind of loss now claimed was, at the time the contract was made, reasonably contemplated as a serious possibility . The judge decided that it was in the contractor’s reasonable contemplation as a serious possibility that an assignee would incur repair costs because of a breach by the contractor.

Key takeaways 

The Court of Appeal decision in Abbey was significant because many forms of collateral warranties in use were thought likely to be a construction contract. However, the appeal to the Supreme Court means that the right to bring adjudication proceedings in relation to a collateral warranty is still unclear. Until such position is clarified, there is significant risk that using adjudication to resolve a dispute under a collateral warranty could be subject to a successful jurisdictional challenge. 

Beneficiaries who have been assigned the benefit of a collateral warranty will take comfort in the upholding of the no loss provision in Orchard Plaza which is wording commonly used in well-drafted collateral warranties. However, warrantors and their insurers will be more anxious to limit the scope of any assignment provisions and also perhaps, to limit their liability.

Watch this space! We will provide a further update once the Supreme Court has made a decision on Abbey.

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