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.3 min read
2. How Collateral Contracts Work
3. Collateral Contract Examples
4. Bipartite and Tripartite Collateral Contracts
5. The Parole Evidence Rule
6. Consideration and Estoppel
Updated November 10, 2020:
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.
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- The incorporation of these terms in the main contract is superseded by rules of evidence.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.
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
Collateral Contract Examples
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.
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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