Rights of set-off and collateral warranties: new case

United Kingdom

A contractor providing a collateral warranty to an owner may be able to exercise rights of set-off to reduce or extinguish its liability under that warranty. The effect may be to require the owner to shoulder some or all of the burden of an intermediate developer’s failure to pay the contractor.

In Safeway Stores Ltd v Interserve Project Services Ltd [2005] EWHC 3085 (TCC) Safeway, as owner of the site, appointed a developer to design and construct a new supermarket and car park. The developer in turn appointed a contractor – Interserve – who provided a warranty in favour of the owner. The key facts are that:

  • The contractor’s workmanship was allegedly defective. The owner sued the contractor for breach of warranty, seeking to recover the cost of repairing the defects. The amount claimed by the owner was in the order of £400K.
  • The contractor defended the claim on the basis that it was owed a substantial amount of money by the developer, which was in liquidation. It said that under the terms of the warranty it had a right to equitably set this amount off against anything it had to pay the owner for the alleged defects. It was not in dispute that the amount owed to the contractor by the developer was some £1.26m. In effect, if the contractor was right, the owner’s claim would be extinguished.
  • The relevant term in the warranty was as follows:

“The Contractor shall owe no duty or have any liability under this deed which are greater or of longer duration than that which it owes to Developer under the [building contract between the developer and the owner]”.

  • By contrast the owner argued that the reference to ‘liability’ in clause 3.3 referred only to the cost of the remedial works. It should not take into account any right of set-off.

Mr. Justice Ramsey agreed with the contractor – the limitation clause extinguished its liability to the owner. In effect, ‘liability’ could not be ascertained just by looking at the cost of the remedial works in isolation. The judge considered that, if the developer had not gone into liquidation, it would have had to take account of the sums it owed to the contractor in settling any claim for defective works. The contractor’s right to payment constituted an equitable set-off which was not merely a procedural rule but a substantive defence to the claim.

The judge found this consistent with the ‘step-in’ mechanism of the warranty. Had the owner decided to step into the developer’s shoes under the contract, the owner would have had to pay the sums owed by the developer. There was no reason to suppose that this apportionment of risk would be different where the owner sued under the warranty instead.

Whilst not clearly drawn out, Mr. Justice Ramsey seems to have viewed the owner’s recourse under the warranty was analogous to an assignment. Since an assignment is taken ‘subject to equities’ (in this case, subject to the contractor’s claim for payment), so again the owner’s rights under the warranty should be so limited.

This case will certainly not leave warranty beneficiaries feeling safe. The form of clause 3.3 is essentially the same as the JCT collateral warranties, widely used across the industry. Whilst there has been some ambiguity, it was thought by many that ‘liability’ meant the contractor’s liability without having to take into account any defences which might be said to be ‘personal’ to the employer. Following this case, a warranty recipient would be wise to insist that its warranty clearly states that the defence of equitable set-off (and possibly all forms of set-off and counter-claim) are not to be taken into account in the limitation clause.

This article first appeared in our Construction and development legal update Spring 2006. To view this publication, please click here to open it as a pdf in a new window.