Game, set-off, match

EVery construction project begins with an explosion in a paper factory, followed by a blizzard of collateral warranties and third-party rights. Such warranties and rights provide vital protection to funders, purchasers and tenants, particularly "step in" rights for funders in the event of developer insolvency, and contractual rights of redress to purchasers and tenants if there are defects.

Nobody is spared. Because of the ever-present spectre of insolvency, lawyers acting for funders, purchasers and tenants have been able to argue that they need warranties or rights from all on the supply side, including all subcontractors. Conventionally, this has included all subcontractors that have "design responsibility" (and who doesn't?). More recently and sensibly, key subcontract packages are specified.

Yet there has not been a corresponding growth in litigation. Perhaps this is because, in most cases, the developer or its contractor actually carries out remedial works. Perhaps it is because the cost of repairing defects doesn't warrant the effort and risk of litigation. Perhaps it is simply because, with the passage of time, defects and maintenance blur and the property management team just gets on with it.

But Safeway Stores, now part of Morrisons, was not deterred when defects came to light in a car park in Oxted, Surrey. Safeway had engaged Chelverton Properties to design and build a supermarket as well as the car park. Chelverton employed Interserve Project Services as contractor. Defects appeared, were patched up and a certificate of making good was issued. The problems continued. The subcontractors argued that the problems were caused by mechanical damage and the absence of an inspection or maintenance regime. Interserve disputed liability. Safeway carried out the remedial works itself.

Meanwhile, Chelverton and Interserve met to deal with the final account. The compromise they reached was disputed. When the case eventually went to court, the judge found that it related only to the final account and did not let Interserve off the hook in relation to defects. It's surprising there could be a dispute about this - the lesson is to document settlement agreements properly.

Chelverton went bust without paying Interserve. Safeway then sued Interserve under the collateral warranty. So, Safeway had remedial costs of about £400,000, allegedly due to Interserve's breach of contract, that it was seeking from Interserve because Chelverton was insolvent. Interserve was due a little more than £1.2m that it could not recover from Chelverton. Who owed whom what?

The issue turned on clause 3.3 of the warranty, which stated: "The contractor shall owe no duty or have any liability under this deed that is greater or of longer duration than that which it owes to the developer under the building contract."

Did the risk of Chelverton’s insolvency and its failure to pay Interserve fall on Interserve or Safeway?

Safeway argued that "liability" did not mean financial liability and that Interserve could not set off amounts owed to it by Chelverton against what it owed to Safeway. To interpret clause 3.3 in this way would mean Safeway's claim was defeated exactly in the circumstances where the rights were intended to exist, namely Chelverton's liquidation.

Interserve argued that clause 3.3 was intended to prevent Interserve from having a liability to Safeway that was greater than its liability to Chelverton, and therefore brought in rights of set-off. If the claim had been brought by Chelverton, Interserve could have cross-claimed for the amounts due to it. Accordingly, Safeway was subject to that same claim.

The issue boiled down to whether the risk of Chelverton's failure to pay Interserve fell on Interserve or Safeway.

The judge said it fell on Safeway and Interserve's liability to Safeway was restricted by clause 3.3 to Interserve's equivalent liability to Chelverton.

What do you think? It probably depends whether you sit on the demand or the supply side. If you are a funder, purchaser or tenant, you will probably seek the insertion of the words "ignoring any rights of set-off or deduction" in terms equivalent to clause 3.3 in your next collateral warranty.