We owe you but you owe us - can we set off the payments?

If two parties each owe each other money, then sometimes the law may assist by permitting the smaller amount to be offset against the larger, resulting in a single payment of the difference. However, it is not the case that unless our contract says otherwise then we are automatically entitled to set off any claim. We need to be aware of the conditions and restrictions of this and tailor our contracts accordingly.

We owe you but you owe us - can we set off the payments?

If two parties each owe each other money, then the law may assist in certain cases by permitting the smaller amount to be offset against the larger, resulting in a single payment of the difference. This can reduce the number of legal actions and where claims are closely connected then it can be fairer for all. However, it is not the case that unless our contract says otherwise then we are automatically entitled to set off any claim against our other party and just pay the net amount.

The classic example is where a seller of goods is owed the price of the goods, but the goods did not meet the requirements of the contract, or caused damage, so the buyer also wishes to claim against the seller (a “cross-claim”). We’ll use that example here, though it’s certainly not the only area where a set off may arise.

So, in English law, we find rights of set off in various guises:

a) Equitable set off

This is helpful for us to be aware of. Even if no provision is made in the contract regarding any set off then the buyer may have an equitable right of set off (also called a “transactional set off”). This can apply if the seller has not been paid but the buyer has a cross-claim against the seller that is “so closely connected” with the seller’s claim for the price that it would be “manifestly unjust” to force the buyer to pay in full and claim separately for the breach of contract by the seller. The key here is that the claims must be so closely connected as to make it unfair not to allow the set off. In our example, they arise out of the same transaction so this seems quite easy to argue. It might also be possible across different transactions between the same parties, though this can be much harder to show. Perhaps two different services contracts for work on a single project could be so closely connected. Or possibly a software licence and maintenance contract. It will depend on the facts of the case.

Exercising this right does not necessarily require any court proceedings to have been brought and can be for an unliquidated amount i.e., one that is not fully ascertainable and would require final assessment by a court or arbitrator. The problem with equitable remedies is that they are always very dependent on the facts of each case and so they bring with them a fair degree of uncertainty. And so we may (particularly if we are the buyer and set off may be important to us in case of poor performance or damage caused to us) resort to:

b) Contractual set off

As a buyer we may want to clarify or even extend our equitable set off rights. So we might insert a term in our contract permitting set offs across different transactions or contracts with the same seller even if they are not intrinsically linked, or even across transactions between other group companies (e.g. where the seller has multiple entities providing goods or services to us in different countries).

As a seller, we are generally interested in getting paid in full every time and dealing separately with any cross-claims. So we will often feel that rights of set off unduly favour the buyer and wish to resist the existence of such rights in the contract, and even insert a term seeking to exclude all possible set offs, counterclaims, abatements and other deductions. Even if we can’t achieve this, then we might feel that a fair compromise would be to limit rights to dispute our invoices as far as we can – e.g. stipulating a certain reasonable time for examination of the goods, for review of revenue reports etc. after which no claims will be permitted and the full price will be due. As a long-stop we might consider placing a contractually agreed limitation period e.g. one or two years, shorter than the standard limitation periods for breach of contract actions, which can draw a line under the ability to raise claims, and mean that the relevant personnel and evidence are more likely to be available when any claim needs to be assessed.

When seeking to exclude or limit rights of set off, we need to bear in mind that, in consumer contracts, terms that exclude or restrict the consumer’s “option of offsetting a debt owed to the trader against any claim which the consumer may have against the trader” appear on the list of potentially unfair and therefore potentially unenforceable terms in the Consumer Rights Act 2015.

c) Legal set off

This applies as a defence only in court proceedings and only where the amounts are liquidated i.e. known in advance and not needing assessment by the court or arbitrator, and due and payable at the start of the action. So this would probably not apply to our buyer’s cross-claim for damages under the sales contract. Unless we had agreed a fixed amount of liquidated damages. However, this defence can apply more widely than equitable set off as the claims do not have to be intrinsically connected.

d) Insolvency set off

Just something to be aware of. Overriding the rules on legal, contractual or equitable set offs, under English insolvency laws if one of the parties becomes insolvent, them there is a mandatory, statutory set off which requires mutual debts, mutual credits and mutual dealings arising before the insolvency to be accounted for between the insolvent party and the creditor. These are then set off leaving only the balance (if any) to be claimed under the insolvency. This seeks to avoid unfair situations where the solvent party could be obliged to pay debts they owed in full, but then be left to claim debts owed to them out of the (usually small or non-existent) amount left to be distributed generally amongst all the creditors in the insolvency proceedings.

e) Banker’s set off

This is a very specific right that banks may have over a customer’s current accounts: within certain limitations, and subject to any alternative agreement, it may allow them to set off a positive balance in one account against an overdrawn account.

f) Construction contracts

Be aware that in construction contracts special rules apply, including a requirement to give prior notice of the intention to reduce payment.

Conclusion

If set off is likely to be important to us – usually if we are the buyer – then we will be well advised to include a clause in our contracts specifying that we have a contractual right to do so. That way we are not limited to the more restricted equitable set off rules and can create a wider possible defence to actions for non-payment. If we are the seller then often we will want to exclude or restrict the buyers’ rights of set off so we can be in a better position to recover the full amount of the debt, subject to ensuring that our clauses meet the requirements of reasonableness or fairness under unfair contract terms and consumer rights legislation.


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