Ready, set-off, go!

Parties often claim a right of set-off where they have competing claims against each other, but just what it is a right of set-off and when and how does it apply?

What is set-off?

When two parties have monetary debts against each other, a right may arise to “set-off” the debts. A party can look to reduce its liability on one contract by setting off that liability against debts due under another contract (or the same contract). The right of set-off can act as a defence to part or the whole of a claim.Although the calculations may be simple, it can be difficult to determine if and when the right of set-off arises. There are different types of set-off (such as banking, insolvency and legal set-off) but for the purposes of this article, we are only looking at contractual and equitable set-off. 

Contractual set-off

Parties can agree a contractual right of set-off by including a set-off provision in a contract. A set off-clause will usually provide clarity as to what remedies of set-off are available and when they can be applied before a dispute arises. Parties can also agree to exclude set-off rights from a contract.

Equitable set-off

In the absence of a contractual right of set-off, there may be an equitable right to set-off. Equitable set-off is more difficult to use in practice than contractual set-off due to the nature of the conditions which must be satisfied.

How and when could an equitable right of set-off arise?

The following test derived from Geldof Mettalconstructie NV v Simon Carves Limited (2010) EWCA Civ 667 can be applied to determine whether a party has a right to equitable set-off:1)     a formal requirement of close connection between the claim and cross-claim; and2)     a functional requirement where it would be unjust to enforce the claim without taking the cross-claim into account.The above test is not a two-stage test but a test with two elements that cannot be separated from each other. The two elements ensure the test is based on principle and highlights that the basis of the set-off rule is fairness. The test will therefore be applied more on a case-by-case basis.Equitable set-off is more likely to be available where the cross-claim arises out of the same contract as the claim, than where the claim and cross-claim arise out of different contracts. However, in Geldof, the Defendant relied on a cross-claim for damages for the Claimant’s repudiation of a contract (B) and was held to have established a right to set-off. The Court found that by demanding payment under contract A as a condition for continuing work under contract B, the Claimant had itself linked the two contracts. 

Important points to note

Equitable set-off can be used not only as a defence for the claim but also as grounds to withhold payment of a debt.Set-off is not the same as a counterclaim. The right to set-off can only be used as a defence, protecting the defendant against a claim, whereas a counterclaim is a separate claim entirely.If you are a party that is expecting payment then it is a real advantage to include in the contract ‘a no right of set-off’ clause. This prevents payment being withheld or held up because of a cross-claim and ensures speedy payment. If there is no right of set-off, the other party will still be able to pursue their counterclaim but will not be able to use it as an excuse to delay payment.