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Consider adding set off to company toolkit

04 August 2009

Setting off one debt against another - and avoiding having to make a payment that would otherwise be due - can be a useful tool, particularly in a recession.

What is set off?

Here is a simple example:

Without the right to set off, A would have had to pay the full £100.

A common example of set off in a commercial context is when a company stops making payment to a supplier because the goods or services provided by the supplier are defective, or have caused the company a loss in some other way, such as a claim by its customer for delays.

Placing a supplier's account on hold in this way can be an effective means of quickly resolving any dispute between the company and the supplier, and protecting the company's cashflow in the meantime. However, it can be a risky strategy, potentially costing the company far more.

When can you set off?

There are a number of types of set off: legal, equitable or set off in insolvency, and each has different qualifying criteria.

Generally, one party will have a claim against another, which has a cross-claim to reduce or extinguish the original claim. The claim that a company wishes to set off against a debt does not have to be for an ascertained sum.

In the above example, A knows that his claim for set off is worth £25. However, A may still have a right to set off if he knows he has a claim, because some of the goods that B supplied for the £100 are faulty, but he does not yet know how much that claim is worth.

Set off is a right that exists unless the contract states otherwise (with a few exceptions). It is usual for terms and conditions of sale to seek to exclude the buyer's right to set off. Such a term will generally be enforceable in a business-to-business relationship, but may be considered unfair - in accordance with the Unfair Contract Terms Act 1977 - in a business-to-consumer relationship.

It is important, therefore, if you are considering placing a supplier's account on hold, to check whether the right to set off has been excluded.

Recent cases have demonstrated that such an exclusion is likely to be upheld by the courts, in a business context, and therefore you could be in breach of contract, and potentially liable for damages for the unlawful termination if you cease making payments under the contract in these cases.

Another important point to note is that the claims must be due between the same entities. For example, you cannot set off a claim due from a subsidiary company against a claim brought by its parent.

Factored invoices

A claim of set off should be approached with caution against a supplier that has factored its invoices. The right to set off is not extinguished, but is curtailed, and a debtor may only claim set off if the right has accrued before the notice of assignment of the debt to the factoring company is received.

Each case will turn on its own facts, and it is recommended that legal advice is sought before placing on hold the account of a supplier that factors its invoices.

What does this mean?

In circumstances where you have a valid claim for set off, which has not been excluded, you may be able to avoid payment of a debt that would otherwise fall due.
This is especially useful in circumstances where the other party is insolvent.

A good example of this is the recent case of The Commissioners for Her Majesty's Revenue and Customs v Xicom Systems [2008] EWHC 1945, where Xicom sought to enforce a costs order made by the VAT tribunal against HM Revenue & Customs (HMRC).

HMRC was able to set off its liability against an outstanding county court judgment against Xicom concerning unpaid taxes. Xicom had since become insolvent and, without the ability to set off, HMRC would have faced having to pay out on the costs order, while being unable to recover on the judgment.

It is, however, important to consider the possible consequences if you claim set off incorrectly:

What should you do?

To ensure you are in the best position to take advantage of the right to set off, or to protect yourself from someone claiming it against you, you should:

© Shoosmiths. This page is for general information: it is not legal advice. Please read our full terms and conditions for details of the disclaimers and exclusions which apply.

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Linda Mattingly

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