Managing cash flow is of the utmost importance to parties at all levels in the construction supply chain. One way of seeking to manage cash flow is to use the right of set-off and including a contractual set-off clause can provide significant benefits.
The principle behind set-off is clear. It allows for the offset of competing monetary claims to produce a single amount owed by one party to another. A party can set off sums payable either:
- against sums recoverable under the same contract, or
- under one contract against sums recoverable under another
It is therefore important to understand how and when a right of set-off can be validly exercised.
Various rights of set-off exist under English law with no need for a contractual set-off clause:
- legal set-off allows a court to give a judgment for the balance due between two parties for reciprocal claims which are unconnected to and independent of each other. Legal set-off can only apply where both of the claims are liquidated or capable of being ascertained with certainty and ease. It is not generally available as a self-help remedy outside of litigation and applies to debts only. Further, it is to be used as a shield and not a sword - so it can be used only as a defence to a claim
- equitable set-off allows a party to set-off a cross-claim against another party provided that it is 'so closely connected with the original claim that it would be manifestly unjust to allow the claim without taking into account the cross claim'. It can only be used for closely connected claims, which does not necessarily mean that they must be under the same contract - but it may be difficult to argue equitable set-off for different contracts where the only connection is the contractual parties
What is required is a close connection, which can be determined on the facts of each case. For example, a cross-claim under separate building contracts where both contracts relate to connected works on the same construction project may be a basis upon which to exercise equitable set-off. Unlike in legal set-off, the claims do not have to be liquidated and a right of equitable set-off can be exercised outside of court
- insolvency set-off is a right of set-off that arises under insolvency legislation if a contracting party to a building contract becomes insolvent. Insolvency set-off is mandatory, which means that it cannot be restricted, extended or contracted out of by agreement of the parties and takes precedence over other forms of set-off exercised before the insolvency
The problem with these various rights of set-off is that each is subject to different limitations.
Contractual set-off clauses can be included in building contracts in order to give clarity as to what specific remedies of set-off are available to parties and when. This allows the parties to extend or limit the general set-off rights available to them in order to clarify the precise circumstances in which set-off can be exercised before any dispute arises.
A contractual set-off clause would, for example, grant the express power to a party to set off a claim under an unconnected contract between the same parties. It can account for - or specifically discount - future or contingent claims that are not yet due and payable such as future payment of liquidated damages. It is important that parties set out clearly what rights exist between them at an early stage in order to avoid confusion and disputes at a later date.
Care should be taken when inserting a set-off provision into a building contract. The Unfair Contract Terms Act 1977 can apply in some business-to-business transactions where the terms are deemed to fail the 'reasonableness test'.
It is also important to remember that the starting place for making a valid deduction from a payment due under a building contract is a timely and valid 'pay less notice'. If no valid pay less notice is or has been issued, any attempt to exercise a right of set-off may fail.
This document is for informational purposes only and does not constitute legal advice. It is recommended that specific professional advice is sought before acting on any of the information given.