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16 October 2024

Collateral warranties – Are they ‘construction contracts’ which can be adjudicated?

Introduction

Collateral warranties are commonplace in the construction industry. They give third parties contractual rights against contractors should defects arise in respect of the works carried out by them.

However, does a collateral warranty amount to a ‘construction contract’ within the meaning of Section 104(1)(a) of the Housing Grants (Construction & Regeneration) Act 1996 (“Act”) so as to give rise to a right to statutory adjudication?

The UK Supreme Court recently clarified this point in the case of Abbey Healthcare (Mill Hill) Ltd v Augusta 2008 LLP (formerly Simply Construct (UK) LLP) [2024] UKSC 23.

Background facts

Simply was hired by Sapphire Building Services Ltd ("Sapphire") under a JCT Design and Build Contract 2011 ("Building Contract") to design and construct a 65-bedroom care home in Mill Hill, London ("Property") in June 2015. Simply completed the works in October 2016. The Building Contract was then novated from Sapphire to Toppan Holdings Ltd ("Toppan") in June 2017. In August 2017, Toppan granted a 21-year lease of the Property to Abbey, which subsequently operated a care home business at the Property.

In August 2018, Toppan discovered several fire safety defects at the Property and requested Simply to rectify them. Simply did not perform the rectification works. Consequently, Toppan had to hire third-party contractors to complete the necessary rectification, which were paid for by Abbey.

Sometime in September 2020, Simply then provided a collateral warranty to Abbey and Toppan (“Collateral Warranty”). The Collateral Warranty provided, among others, that Simply “has performed and will continue to perform diligently its obligations under the [Building] Contract” and that in carrying out and completing the works, Simply “has exercised and will continue to exercise all the reasonable skill, care and diligence to be expected of a properly qualified competent and experienced contractor…”.

The adjudications

Toppan and Abbey subsequently initiated 2 separate adjudications against Simply arising from the fire safety defects and the costs for the rectification works. One single adjudicator was appointed for both adjudications.

Abbey’s claim in the adjudication was premised on the Collateral Warranty. Simply challenged the jurisdiction of the adjudicator on the grounds that the Collateral Warranty was not a ‘construction contract’ within the meaning of Section 104(1) of the Act.

The adjudicator found in favour of both Toppan and Abbey and awarded them damages of approximately £1 million and £869,500.00 respectively. Simply did not pay the amounts awarded.

The High Court

Toppan and Abbey therefore sought enforcement of the adjudication decisions in the Technology and Construction Court (“TCC”).

The TCC granted summary judgment to Toppan but declined to do so for Abbey. This was because the High Court judge found that the Collateral Warranty was not a ‘construction contract’ within the meaning of Section 104(1) of the Act and therefore the adjudicator lacked jurisdiction.

The Court of Appeal

Abbey then appealed to the Court of Appeal. All members of the panel in the Court of Appeal agreed that a collateral warranty could amount to a construction contract. A majority of the panel allowed Abbey’s appeal, finding that the collateral warranty in this case amounted to a construction contract.

Stuart-Jackson LJ dissented, finding that the wording of the Collateral Warranty were warranties of performance of obligations owed to the employer of the Project (i.e. Sapphire/ Toppan). They were not clauses in which Simply undertakes a direct obligation to Abbey to carry out the construction works, and therefore cannot amount to a construction contract.

The Supreme Court

Simply appealed to the Supreme Court. The Supreme Court unanimously allowed the appeal. The appeal raised 2 issues, namely:

  1. What is the meaning of an agreement “for… the carrying out of construction operations” within the meaning of Section 104(1) of the Act (“Statutory Interpretation Issue”)? and
  2. How should the Collateral Warranty be construed and, so construed, is it an agreement “for… the carrying out of construction operations” (“Contractual Interpretation Issue”)?

Statutory Interpretation Issue

The Supreme Court determined that Section 104(1) of the Act necessitates evaluating whether the primary aim or objective of the agreement involves the carrying out construction operations. Generally, the purpose of a collateral warranty is to provide the beneficiary with a right of action concerning defective construction works, rather than the carrying out of the construction operations itself. Such a collateral warranty does not result in the carrying out of the construction operations – it is the building contract which does so.

Based on the above, the Supreme Court concluded that a collateral warranty does not amount to an agreement "for" the carrying out construction operations if it merely promises to perform obligations owed to someone else under a building contract. There must be a separate and distinct obligation to perform construction operations for the beneficiary, rather than an obligation that is merely derivative or reflective of obligations owed to someone else under the building contract.

Contractual Interpretation Issue

Regarding the second issue, the Supreme Court ruled that the Collateral Warranty does not amount to a construction contract within the meaning under Section 104(1) of the Act. The Court reviewed the majority’s decision in the Court of Appeal, noting that a key factor in the majority’s decision was clause 4.1(a) of the Collateral Warranty, which stipulated that Simply promised Abbey that it... “has performed and will continue to perform diligently its obligations under the [Building] Contract”.

The Supreme Court found that this promise was purely derivative, with Simply not committing to anything beyond what was already promised under the Building Contract. The Court held that if the approach taken by the majority of the Court of Appeal were adopted, any collateral warranty with a promise similar to that in clause 4.1(a) would be considered a ‘construction contract’ under Section 104(1), even if all construction work had already been completed at the time the collateral warranty was executed.

The Supreme Court held that the majority’s approach in the Court of Appeal in determining whether or not a collateral warranty would amount to a construction contract would depend on the niceties of language and may lead parties to drawing fine distinctions in relation to the drafting and interpretation of collateral warranties.

Instead, the Supreme Court advocated for a "more principled and practical approach," which involves distinguishing between collateral warranties that simply replicate obligations from the building contract, and those that create separate or distinct obligations for the carrying out construction operations. Applying this approach, the Supreme Court concluded that the Collateral Warranty does not constitute a construction contract.

The Supreme Court further determined that this approach would likely mean that most collateral warranties do not qualify as construction contracts. However, there are good reasons for concluding that such warranties were generally not intended to fall within the Act and that one of the main purposes of the Act, which is to improve cashflow, is not furthered by the application of the Act to collateral warranties

Comments

It would be interesting to see if the Malaysian courts would adopt a similar approach when deciding whether collateral warranties fall within the meaning of  a “construction contract made in writing relating to “construction work” under Sections 2 and 4 of the Construction Industry Payment and Adjudication Act 2012 (“CIPAA”).

For completion, Section 4 of CIPAA provides the following definition for the term “construction work”:

“… the construction, extension, installation, repair, maintenance, renewal, removal, renovation, alteration, dismantling, or demolition of-

(a) any building, erection, edifice, structure, wall, fence or chimney, whether constructed wholly or partly above or below ground level;

(b) any road, harbour works, railway, cableway, canal or aerodrome;

(c) any drainage, irrigation or river control work;

(d) any electrical, mechanical, water, gas, oil, petrochemical or telecommunication work; or

(e) any bridge, viaduct, dam, reservoir, earthworks, pipeline, sewer, aqueduct, culvert, drive, shaft, tunnel or reclamation work,

and includes-

(A) any work which forms an integral part of, or are preparatory to or temporary for the works described in paragraphs (a) to (e), including site clearance, soil investigation and improvement, earth-moving, excavation, laying of foundation, site restoration and landscaping; and

(B) procurement of construction materials, equipment or workers, as necessarily required for any works described in paragraphs (a) to (e).”

It is important to look at how the Malaysian courts have previously interpreted the definition of “construction work”. For example, in YTK Engineering Services Sdn Bhd v Towards Green Sdn Bhd and other applications [2017] MLJU 632, the High Court found that the dispute, which related to a joint venture agreement, was in essence a profit-sharing contract and not a contract for construction work, even though the underlying subject matter of the contract was for construction work.

Given the specific definition of “construction work” in CIPAA and the manner in which the Malaysian courts have interpreted that term, it is likely that if a similar issue relating to collateral warranties were to arise in Malaysia, the Malaysian courts may adopt a position similar to that adopted by the Supreme Court in the Abbey case.

This article is authored by Balan Nair Thamodaran (Partner) and Reuben Raphael Joseph (Senior Associate) of the Construction and Adjudication Practice of Lavania & Balan Chambers. It contains general information only. The contents are not intended to constitute legal advice on any specific matter nor is it an expression of legal opinion and should not be relied upon as such.