Set-off: Know the setbacks

What we are talking about, when we use the term “set-off”, is an ability of one party to avoid paying what would otherwise be due to another party.

The importance to businesses and traders in terms of cash flow and risk is pretty straightforward. The phrase “cash is king” may be a bit outdated in this modern age, but the principle still holds true. If it were not for the ability to set-off, a party may find itself in the uncomfortable position of having to pay out in full despite having a legitimate cross-claim. Abatement may be relied upon to reduce a payment due, but the ability to reduce the amount is purely limited to the issue of the quality of produce or service being offered as opposed to non-performance of other obligations, which may not be relevant in certain circumstances.

There are various rights of set-off under general law, but there are certain restrictions which apply to each which means that these can only be used where certain facts are present.

To rely on legal set-off a party must have a liquidated (clearly ascertained) claim, but this type of set-off can only be used as a defence to proceedings (for example in Court or in adjudication). As such, a party cannot use legal set-off as a means of setting-off in a pay less notice. It is worth noting that the amounts can arise out of different contracts, in contrast to equitable set-off, which I will deal with next. The fact that there must be proceedings which have been issued before a party can seek to use this means of set-off is not particularly helpful when considering the practical cash flow aspect.

Even where the same parties entered into nine subcontracts on the same day for similar services for different projects, the court found that these contracts were unconnected for the purposes of equitable set-off

Alternatively there is “equitable set-off”. Here there is no need for the amount to be set-off to be a liquidated ascertained sum (for example damages for delay and disruption). What has to be demonstrated, however, is that there is a close relationship between the dealings which gave rise to the parties’ respective claims. Typically this means that the claims need to arise out of the same contract. The courts have considered the circumstances where a party has sought to set-off amounts arising out of other contracts using the principle of equitable set-off and the decisions demonstrate that parties may struggle to comply with this requirement.

For example, in this particular case, even where the same parties entered into nine subcontracts on the same day for similar services for different projects, the court found that these contracts were unconnected for the purposes of equitable set-off.

Both these types of set-off show that there is a gap in the general law where proceedings have not been issued and a party wants to be able to set-off an amount against the same party, but arising out of an unrelated contract. This is why a paying party, for cash flow reasons, will seek to include clauses entitling it to set-off amounts relating to other contracts against monies due. In circumstances where there is a longstanding commercial relationship and multiple contracts are being awarded, the other contracting party may well be willing (or have to) to accept such a provision.

The final type of set-off is insolvency set-off. This type of set-off is triggered under the Insolvency Rules and effectively operates by netting off all sums due between the creditor and debtor party. Insolvency set-off supersedes any contractual rights of set-off. The position is different depending on whether the company goes into liquidation or administration. The principles of insolvency set-off apply immediately upon the liquidation of the company, whereas where the company is in administration this is triggered at the point when the administrator gives notice of an intention to distribute to creditors.

Therefore, if there is an adjudication running when insolvency set-off is triggered (e.g. one of the parties goes into liquidation) any claims and cross-claims between the parties, whether in the contract that is the subject matter of the adjudication or other contracts, will be replaced by a claim for the net balance under the insolvency rules due to the priority of the insolvency rules of set-off.

What is clear from this is that the law of set-off has complexities that parties may not be aware of. Parties need to consider the general law and any contractual provisions regarding set-off carefully as these may well operate to change what may have been previously considered a relatively straightforward position.

Steven Carey is head of construction and engineering at Speechly Bircham