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Set-off on the right foot: a practical guide to set-off

  • United Kingdom
  • Construction and engineering

22-11-2017

Employers and Developers typically undertake multiple construction projects at the same time, and normally, having built a successful working relationship and track record with a good professional team or selection of contractors, they will use that same team on the majority of their projects, engaging them over several different projects or for several elements of the same project. With that in mind we discuss here how clients may benefit from the use of the right to “set-off” or from the use of exclusion of set-off.

What is set-off?

In certain circumstances, where two parties have monetary debts against each other, the right to set-off may arise. A right of set-off allows a (“Party 1”) to take into account the amount owed to it by the second party (“Party 2”) against any amount owed by Party 1 to Party 2, each party must be a debtor and a creditor.

Common law provides the key features that must be present for set-off to arise are;

  1. mutuality of debts (each party must be the sole beneficial owner of the debt it is owed and the sole person liable for the debt it owes)
  2. the claims each party has must be for non-payment of money

The common law provisions of set-off can be greatly enhanced by the inclusion of a contractual right to set-off (this is discussed further below) so that set-off is applicable in a greater range of situations. If you envisage set-off being a useful right it is not advisable to rely on the implied ability to use it (via common law or equitable set-off). Common law and equitable set-off are subject to various conditions and limitation however, a contractual right of set-off can be drafted to ensure parties are able to agree exactly how and when set-off should be applied.

Example: An Employer (“E”) enters into a contract with Consultant (“C”) for C’s project management services for which it is agreed E will pay £50,000 (“Contract A”), E also enters into another contract with C for C’s engineering services for which it is agreed E will pay £80,000 (“Contract B”). If E establishes a claim against C in respect of Contract B due to faulty workmanship which causes £30,000 worth of damage can E off-set one contract against the other and pay C just £100,000?

The types of set-off

There are several types of set-off in addition to those discussed below (such as insolvency set-off and statutory set-off) but for the purposes of this article we are looking only at contractual and equitable set-off.

1.    Contractual

A contractual right of set off enhances the common law rights available to a party, for example a well drafted contractual set-off clause can be used to:

  1. allow parties to agree when set-off should apply;
  2. allow parties to agree that set-off should not apply;
  3. allow parties to set-off claims that are not mutual (eg where a party wants to set-off a debt owed to that party by a debtor, against a debt that that party owes to a third party); and/or
  4. allow parties to set-off claims that are not due and payable at the time.

Including an express set-off provision gives the parties clarity as to what remedies of set-off are available (or not) and when they can be applied, before a dispute arises. Commonly parties try and restrict the right to set-off in their contracts. However, a contractual provision can be used to give either or both parties set-off rights that otherwise would not be available. In our example above, the contract would have to set out an express contractual right to allow for cross contract set-off as Contract A and Contract B are two separate contracts. Unless an express contractual provisions existed, E would have to pay £50,000 under contract A and then claim £30,000 for the damages under Contract B.

2.    Equitable

In our example above, suppose the two contacts relate to the same project but no contractual right of set-off is provided, nor is it excluded. In this scenario it may be possible that a right of equitable set-off arises despite the fact that the contracts are both silent on the matter. The current case law on the principles of equitable set-off are from Geldof Metaalconstructie NV v Simon Carves Ltd [2010] EWCA Civ 667 in which the Court of Appeal provided guidance on the rules of equitable set-off. Equitable set off is more difficult to use in practice than contractual set-off due to the fact that the claims being set-off have to be of the same nature (ie both contractual) and must be so closely connected that is would be “manifestly unjust”[1] to enforce one without taking the other into account.

Geldof Metaalconstructie NV v Simon Carves Ltd [2010] EWCA Civ 667

  1. In Geldof the Contractor (“S”) entered into a contract with its Employer, to carry out building work, It subsequently entered into two sub-contracts with (“G”), the sub-contracts were for the supply of goods and for installation of other goods respectively.
  2. The provisions of the supply contract between S and G provided that S was able to set off amounts due from G to S whether under that purchase order or not.
  3. The installation contract did not go to plan. S alleged that G had breached the installation contract, S issued a default notice and refused to pay the sums under the supply contract. G in response stopped the installation work until both of G’s invoices for the installation and supply contracts were paid.
  4. S issued a notice to terminate the installation contract and G started proceedings for the goods supplied under the supply contract, S counterclaimed for damages for repudiation of the installation contract.

At first instance the Technology and Construction Court held S was not able to set-off the counterclaim because the supply contract clause was not wide enough to capture unliquidated damages (although they were provisionally quantified) and no equitable set-off was allowed because there was not a close enough connection between the contracts.

The Court of Appeal disagreed with the court of first instance’s decision and provided us with a simple test when considering whether equitable set-off will apply, the test provides that a cross claim must be “so closely connected with [the claimant’s] demands that it would be manifestly unjust to allow him to enforce payment without taking into account the cross-claim”. In deciding whether the two contracts were connected the Court of Appeal placed importance on the fact that G had itself established a connection between the supply and the goods contracts by refusing to perform under one due to none payment in relation to the other.

In any event, the Court of Appeal was prepared to find that the supply contract clause which contained the set-off provision was sufficient to allow S to use contractual set-off. The supply contract set-off clause provided that S could set off “any amounts lawfully due”. The Court decided that “amounts lawfully due” included amounts which have been adjudicated or agreed to be due, and also amounts claimed to be due and that are recognised at law. Therefore even if equitable set-off had not been deemed applicable, contractual set-off would have been.

Can an adjudicator’s award be set-off?

There is no blanket rule in relation to set-off of sums awarded by an adjudicator against other sums that are due or set-off of sums due against an adjudicator’s award, the ability to do so is very fact specific. Generally, set-off against an adjudicator’s award will not be permitted except:

  • in the event the adjudicator decides as part of his/her award that set-off should be permitted;
  • if an adjudicator decides that a sum claimed is not yet due, if this happens then once that sum is certified any genuine set-off may then be raised; or
  • an express term permitting set-off against sums awarded by an adjudicator is included within the relevant contract.

Interplay with the Construction Act

Section 110(1A) pf the Construction Act states that payment to a party cannot be made conditional on the performance of obligations outside of the contract. There is an argument therefore that this provision defeats the ability to use “cross-contract set-off”. This is currently a point of judicially undecided law. Several commentators have offered their opinions on this point, which fall both ways. Whilst the Construction Act does not expressly refer to cross-contract set off, it is also possible to see how a court may interpret section 110(1A) to preclude cross contract set-off.

What about abatement?

Abatement is a separate and different right from set-off. It is a defence which can be invoked by a defendant where the goods and services supplied by the claimant do not justify the payment agreed by the defendant. Therefore the person who instructed the work may reduce the price that was agreed to be paid for that work because the work has not been done properly and/or it has not been completed. Although this is similar to set-off, abatement is a means of adjusting the amount payable, it does not require there to be a separate cross-claim.

Abatement refers to the quantification of the sum-due which is in contrast to the right of set-off which may constitute a ground for withholding all or part of a payment. Abatement is an issue that should be raised at the valuation stage, or at the latest when the payment notice is required to be given, whereas set-off should be raised via a valid withholding notice issued at the relevant time. Therefore whilst connected, abatement and set-off will apply at very different times, to different situations.  

It is worth noting that abatement is generally not available in respect of professional services. The courts have said however, that a deduction (from a consultant’s fees for example) could be claimed via abatement if all or an ascertained part of such services were either not performed or were performed so badly that they are worthless. It will be rare that an employer can show that a consultant’s services (or a part of them) have been entirely worthless, hence why it is far more common in cases of professional negligence for employers to utilise the right to set-off or counterclaim.

Summary

Cross contract set-off is potentially relevant whenever two businesses engage with each other under multiple contracts. Without set-off, a relevant monetary demand would likely have to be met immediately which may impact a company’s cash flow. Set-off can be used as a defence for non-payment which can mean it equates to a defence for an action that would otherwise have been classed as a breach of contract.

As we saw in Geldof, even without an express contractual provision, equitable set-off can step in to assist a party but, despite the helpful judgment in Geldof, whether set-off is applicable will still be judged on the facts of the case and it is clear there is potential for judicial discretion in cases of this kind. Whether set-off is something that you want to include or exclude, a contractual provision that makes it clear to both parties when and how set-off will be engaged will be more likely to protect both parties’ interests and minimise the chance that a dispute might go to adjudication or court.


[1]               Rix LJ in Geldof Metaalconstructie NV v Simon Carves Ltd [2010] EWCA Civ 667

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