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As part of your business, you frequently enter contracts with other parties. Therefore, you must be aware of collateral contracts and how they may benefit your commercial arrangement. Conversely, you should know how collateral contracts form so you can avoid unintentionally entering one. This article will discuss the elements of a collateral contract and the consequences of breaching it. 

What is a Collateral Contract?

Generally, a collateral contract can be a verbal statement or a separate written statement to the main contract. Once established, it exists independently of the main contract. Therefore, if the main contract is illegal (and thus unenforceable), the collateral contract can still be valid and enforceable.

Examples of Collateral Contracts

Suppose you agree to rent an apartment. The lease agreement you sign with the landlord is the main contract. However, your landlord promises to fix the toilet drainage. Therefore, this is the collateral contract.

Alternatively, let us assume you buy a car. The purchase agreement you signed with the car dealer will be the main contract between you and the car dealer. However, the promise to include thicker car mats may be a collateral contract.

In summary, a collateral contract is essentially a promise that can be enforced but is not a term of the main contract. 

The Parol Evidence Rule

The parol evidence rule states that you cannot use extrinsic evidence to change the terms of a written contract. Extrinsic evidence includes verbal statements or implied agreements you have not written in the original contract. This rule exists to uphold the integrity of a written contract. However, a collateral contract is an exception to this rule. 

Elements of a Collateral Contract

You must demonstrate the following elements are present to prove a collateral contract exists:

  • the statement or document must have been promissory; 
  • the parties did not intend for the statement or document to be part of the main contract; 
  • the statement or document must be consistent with the main contract; 
  • you must provide consideration for the promise; and 
  • all the elements of a contract must be present. 

You must establish the above elements. Furthermore, the collateral contract must be consistent with the main contract and should not alter it. If the statement is inconsistent with the main contract, it will not be a valid collateral contract.

To illustrate how the elements of a collateral contract are addressed by the legal system, here are some examples.

In the case of Adicho v Dankeith Homes Pty Ltd, the Court of Appeal of the New South Wales Supreme Court held that a side arrangement to the main contract was unenforceable because it was inconsistent with the terms in the main contract.

Another example is in the case of Hoyts Pty Ltd v Spencer. The High Court of Australia determined that a collateral contract cannot be inconsistent with the main contract. If it is inconsistent, entering into the main contract alone is insufficient evidence of consideration for the collateral contract to be valid.

Consequences for Breaching a Collateral Contract

Breach of a collateral contract can allow the injured party to seek financial compensation. As such, it is in your business’ interests to avoid unintentionally entering and breaching this agreement. However, the breach will not affect the main contract as it exists independently of the collateral contract.

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Key Takeaways 

A collateral contract is a separate contract that builds on the main contract. It may appear verbally or written as a smaller agreement, but does not form one of the terms of the main agreement. You must satisfy the prerequisite elements to demonstrate a collateral contract exists. Furthermore, once established, a collateral contract will exist independently of the main contract.

It is important for business owners to be aware of collateral contracts and how they arise to ensure that they are aware of all rights and obligations they may have.

If you need assistance understanding whether a collateral contract applies to you, our experienced contract lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1800 534 315 or visit our membership page.

Frequently Asked Questions

What is a collateral contract? 

It is a separate contract that sits in addition to the main contract.

How do I know if a collateral contract exists?

For a collateral contract to exist, it must be consistent with the main contract, be promissory and contain all the elements of a contract. Additionally, the parties must not have intended it to be part of the main contract and you must give consideration for the promise.

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