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
2. Reasons to Create a Collateral Contract
3. How Collateral Contracts Work
4. Are Collateral Contracts Enforceable?
5. Collateral Contract Examples
6. Bipartite and Tripartite Collateral Contracts
7. The Parole Evidence Rule
8. Consideration and Estoppel
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.
- 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- The incorporation of these terms in the main contract is superseded by rules of evidence.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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