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.

Previously, there was also a contractual requirement related to privity. Essentially, this requirement stated that benefits were reserved to the parties listed in the contract. This rule was altered by the Contracts (Rights of Third Parties) Act of 1999. Effectively, this gives third parties certain rights and duties for certain contracts.

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.

These contracts can be either verbal or written agreements and can take place between the two original parties or can involve one of the original parties and a third party. Usually, a collateral contract will be entered at the same time as the original contract. However, the collateral contract is completely separate from the first contract.

There are multiple reasons a collateral contract might be used:

  • The terms of the collateral contract conflict with the original contract terms.
  • The evidence rules take precedence.
  • The original contract has been written incorrectly.
  • A third party needs to be included in the 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.

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.

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