A spot of bother with the builders leaves Britain's £36m 'home of dance' red-faced and flat-footed

There were multi-media installations, bottles of its own mineral water at £4.50 a cultured swig, and a specially commissioned performance by the Rambert Dance Company. Not even a half-hour delay in the curtain going up - caused by the last-minute granting of an entertainment licence - could sour the atmosphere when the Sadler's Wells theatre reopened in October 1998 after being renovated with £36m of Lottery funds.

There were multi-media installations, bottles of its own mineral water at £4.50 a cultured swig, and a specially commissioned performance by the Rambert Dance Company. Not even a half-hour delay in the curtain going up - caused by the last-minute granting of an entertainment licence - could sour the atmosphere when the Sadler's Wells theatre reopened in October 1998 after being renovated with £36m of Lottery funds.

Indeed, when the theatre's chief executive, Ian Albery, walked on to the stage to huge applause waving the vital document from Islington council, the optimism appeared to run as deep as the theatre's 200-metre borehole that provides its expensive bottled water.

That was then. Last night, amid a "worsening financial situation" at the theatre, such optimism looked battered after leaked documents revealed that it was facing a series of legal battles that could threaten its survival. The matter has also reopened the debate about public funds being used to finance what are still considered by some as exclusive areas of the arts. The matter will be raised in Parliament when MPs return in October.

"It's quite a scrap, but I am not worried about that," Mr Albery said last night. "I think I have shown my mettle before."

The renovation itself is at the heart of the problem. The theatre in central London underwent a £48m refurbishment in a project designed to create "Britain's leading theatre for presenting dance". One of the first applicants for lottery funding in 1995, it sought to create an accessible but accomplished arts environment.

But the renovation hit problems from the start. Electrical work that should have been done in less than a year dragged on for 107 weeks. Even though the relevant licences were granted more or less on time, the building work had not all been completed.

To make matters worse, there were other problems after the Royal Opera House pulled out of a six-month season of opera and ballet. This threatened to leave the theatre with a vast gap in its programme and a massive financial shortfall.

The current problem involves the theatre's attempts to recoup some of the money it overspent with contractors. Lawyers for the theatre are considering action against a number of contractors, including the project managers, the construction firm Bovis.

"We are the good guys in all of this," said Mr Albery. "We are the only lottery project that is doing the decent thing and taking to task those responsible for the overspend."

However, the leaked documents of correspondence between the Arts Council - the primary funders of the theatre, which has a role in overseeing its financial management - and its solicitors reveal that the council is seeking advice about a "worst case scenario" that could leave the theatre facing severe financial difficulties.

The documents, from earlier in July, show that the council asked its solicitors, London-based firm Collyer Bristow, to investigate the implications should the legal actions drag on for several years. They refer to "an insolvency situation" and a "worsening financial situation".

Last night a spokesman for the Arts Council admitted that the correspondence between the solicitors and the head of the council's capital services department was genuine. He said the council was only preparing for a worst case scenario. "We are optimistic that it is not going to come to this," he said.

"The theatre is not insolvent but the Arts Council has a responsibility in monitoring such capital investment projects. What we were looking at was the worst case scenario. Sadler's Wells is currently doing very well, but there is an issue about the legal concerns. We have to make an overview and plan for the worst."

To add to the theatre's problems, it in turn is being sued by one of its contractors for alleged non-payment. Goodmarriott and Hursthouse, a Nottingham-based company that won the contract for the project's electrical installation, is taking High Court action against the theatre, claiming it is still owed more than £1m.

A company spokesman said: "We took the decision to commence legal action reluctantly only after we had exhausted all other efforts to recover monies we believe are properly due to us.

"Further payments have been received since we started proceedings, but there is still a considerable amount outstanding."

The company said that it was contracted to carry out work that was estimated to take 49 weeks. In all, it took 107 weeks - a situation the company claims was due to the building not being ready for the electrical work to be carried out.

The spokesman said: "Since proceedings started [we] have made a number of proposals to settle the dispute, none of which have been taken up. As a consequence, legal costs for both parties continue to escalate."

The problems of Sadler's Wells, whose redevelopment was associated by many with the New Labour government, are likely to have some political consequences. Peter Ainsworth, the shadow Culture Secretary, last night called for a revision of all large-scale lottery grants in the wake of the revelations. "I wish Sadler's Wells well because I am an enthusiast of the theatre, but if these reports are true they fit into a well established pattern where large-scale lottery projects which have had capital spending now look as though their revenue requirements are pretty dicey," said Mr Ainsworth. "I expect the Government to be taking a close look at all future revenue requirements of these big lottery projects."

Norman Baker, the Liberal Democrat lottery spokesman, called for a full inquiry into the allegations about the theatre and said he would raise the matter in Parliament. "This is a huge amount of public money that shouldn't have been spent in the first place. Now that it looks like that money may have been wasted and the whole thing in jeopardy, we have a right to know exactly what's been going on," he said.

The Department of Culture, Media and Sport, which oversees lottery funding, declined to comment.

Meanwhile, Mr Albery and the other staff at the theatre continue to remain bullish in the face of these difficulties. "This year 400,000 people will visit Sadler's Wells theatre," he said, adding that there were record advance bookings for the autumn season, which opens on 5 September.

It is a case, Mr Albery might have said, of the show must go on - if it can afford to.