Is a collateral warranty a ‘construction contract’; is the debate now settled?

Case background

Simply (now Augusta) designed and constructed a care home in Mill Hill, London. Abbey Healthcare is the tenant and operator of the care home.

Shortly after the care home was built and opened, various defects in design, construction, and fire resistance, protection, stopping and doors were identified. Augusta was given the opportunity to rectify the defects but declined to do so. The defects were subsequently remedied, but Abbey (and other parties) incurred losses as a result. Abbey successfully brought an adjudication under the Court of Appeal decision to recover their losses, under a collateral warranty from Augusta to Abbey. On seeking summary judgment to enforce the decision, the Court rejected the adjudication decision in favour of Abbey on grounds of jurisdiction.

This question of adjudication rights under collateral warranties first appeared in Parkwood Leisure Ltd v Laing O’Rourke Wales and West Ltd [2013] EWHC 2665 (TCC), where the Court held that a collateral warranty was a construction contract, and that Parkwood was therefore empowered by statute to refer its dispute to adjudication. However, the Court held that not every collateral warranty would be a construction contract – the wording and factual background were to be considered on a case-by-case basis. As a result of Parkwood, many in the industry amended their collateral warranties to restrict or remove express obligations to carry out construction operations.

What did the Court of Appeal say in Abbey Healthcare?

The Court of Appeal found in Abbey Healthcare (Mill Hill) Ltd v Simply Construct (UK) LLP [2022] EWCA Civ 823 that the collateral warranty was a construction contract under the Act. The Court stated that the definition under Section 104(1) of the Act should be interpreted broadly and found that the definition went beyond the underlying contract and included agreements ‘related to’ construction operations under Section 104(5). The Court also confirmed that whether a collateral warranty is a construction contract depends on the wording of the warranty itself: Augusta warranted that it “has performed and will continue to perform diligently its obligations under the contract” (our emphasis), which made it an “ongoing promise for the future” and “an agreement for the carrying out of construction operations”.

The Court of Appeal also held that in determining whether a collateral warranty was a construction contract, the date of execution must be irrelevant both because the warranty is retrospective in effect and on grounds of policy: to decide otherwise would have caused uncertainty and encourage contractors not to sign collateral warranties until after they had finished (which would be unworkable in practice).

The Court of Appeal judgment was not unanimous, and Stuart-Smith LJ disagreed that Section 104(1) should be interpreted broadly, on the grounds that the use of the word “for” is for conventional use. His view was that if Augusta was simply warranting a state of affairs, rather than agreeing direct obligations to the beneficiary, that is likely to indicate that the warranty is not a construction contract. Essentially, the Court agreed (and cautioned against assuming) that not all collateral warranties were construction contracts.

What has the Supreme Court said?

The Supreme Court in Abbey Healthcare (Mill Hill) Ltd v Augusta 2008 LLP (formerly Simply Construct (UK) LLP) [2024] UKSC 23 (9 July 2024) were asked to consider whether the collateral warranty is a construction contract within the meaning of Section 104(1) of the Act. This question raised two issues:

1. What is the meaning of an agreement “for… the carrying out of construction operations” under Section 104(1) of the Act?
2. How should the Abbey collateral warranty be construed, and so construed, is it an agreement “for… the carrying out of construction operations”?

Issue 1: what does the Act say?

Section 104(1) of the Act says that a “construction contract” is an agreement with a person for any of the following:

• a) the carrying out of construction operations;
• b) arranging for the carrying out of construction operations by others, whether under sub-contract to him or otherwise; or
• c) providing his own labour, or the labour of others, for the carrying out of construction operations.

Augusta, relying on the dissenting judgment of Stuart-Smith LJ in the Court of Appeal, argued that the Court of Appeal erroneously adopted a ‘broad’ interpretation of this Section, and the Supreme Court had to assess whether the object or purpose of the collateral warranty was for the carrying out of construction operations. Lord Hamblen found that it was difficult to see how the object or purpose of a collateral warranty is the carrying out of construction operations, as “…the main object or purpose of such a warranty is to afford a right of action in respect of defectively carried out construction works, not the carrying out of such work. Whether or not the carrying out of construction operations has to be the main object or purpose of the agreement, it must surely be necessary for the agreement to give rise to the carrying out of such operations. A collateral warranty that merely promises to the beneficiary that the construction operations undertaken under the building contract will be performed does not do so. In such a case, it is the building contract that gives rise to the carrying out of the construction operations; not the “collateral” warranty. Any obligation undertaken to the beneficiary to carry out construction operations derives from and mirrors the obligations already undertaken under the building contract… There is no distinct or separate obligation undertaken to the beneficiary. There is no promise to carry out any construction operation for the beneficiary; merely a promise to the beneficiary that the construction operations to be carried out for someone else under the building contract will be performed.”

As such, a collateral warranty will not be an agreement “for” the carrying out of construction operations for the purposes of Section 104(1) of the Act, if it only promises to a beneficiary that the construction operations to be carried out for someone else under the underlying contract will be performed. It is clear from this judgment that for a collateral warranty to be a construction contract, there must be a distinct obligation to carry out construction obligations for the beneficiary.

Issue 2: how was the Abbey Collateral Warranty construed?

The Court of Appeal relied heavily on words such as “warrants”, “promise” and “undertakes”, and the “niceties of the language used” in the warranty itself. The Supreme Court held that what mattered was the substance of the promise, rather than its labels. It agreed that the more principled and workable approach would be for the dividing line to be between collateral warranties which merely replicate an undertaking given in the underlying contract, and those which give rise to separate and distinct undertakings for the carrying out of construction operations.

Adopting such an approach is likely to mean that most collateral warranties will not be construction contracts and therefore won’t fall within the scope of the Act. However, there are good reasons for this conclusion:

• the Supreme Court discussed that it is notable how the payment-related provisions of the Act do not apply to collateral warranties: one of the twin purposes of the Act was to improve cashflow, but collateral warranties do not further this cause (consideration is usually nominal – the consideration in the Abbey Collateral Warranty was only £1); unless step-in rights are exercised, a beneficiary under a collateral warranty will not have any construction-related payment obligations; and
• it is in the interests of certainty that there is a clear dividing line, meaning that collateral warranties generally fall outside of the scope of the Act, rather than everything being dependent on the wording of the warranty. This approach will assist those in the construction industry (and their advisors) to know where they stand.

The Supreme Court also highlighted that if the parties wish to have a right to adjudication, this can always be provided for (but noting that adjudication is voluntary rather than mandatory).

Abbey argued that there were provisions in the underlying Building Contract that made specific provision for beneficiary rights (e.g. allowing Abbey to carry out works and access to the Works on site). The Supreme Court held that whilst the collateral warranty may have entitled Abbey to enforce those rights, the rights do not involve or require the carrying out of construction operations by Augusta, and their existence cannot and does not transform the collateral warranty into a contract for the carrying out of such operations.

What does this judgment mean for the construction industry?

This judgment clarifies whether collateral warranties are construction contracts and represents a turning point for collateral warranties in construction law and their use in the construction industry.

The Supreme Court applied a narrow interpretation of the Act, confirming the limits of statutory adjudication. Advisors drafting collateral warranties should ensure that the obligations owed by a contractor under a warranty do not exceed the scope of the Building Contract if they want to avoid the implication of a statutory right to adjudicate.

Beneficiaries of collateral warranties must now pursue any disputes through litigation. This could pose problems for beneficiaries who may have neither the time nor funds to pursue claims through the courts. Beneficiaries and their advisers would therefore be prudent to consider including express contractual rights in their warranties to refer disputes to adjudication, and parties should expect the inclusion of such clauses to become a common feature in negotiations.